Credit (finance)
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Credit (from
Latin Latin (, or , ) is a classical language belonging to the Italic languages, Italic branch of the Indo-European languages. Latin was originally a dialect spoken in the lower Tiber area (then known as Latium) around present-day Rome, but through ...
verb ''credit'', meaning "one believes") is the trust which allows one
party A party is a gathering of people who have been invited by a Hospitality, host for the purposes of socializing, conversation, recreation, or as part of a festival or other commemoration or celebration of a special occasion. A party will oft ...
to provide
money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
or
resources Resource refers to all the materials available in our environment which are Technology, technologically accessible, Economics, economically feasible and Culture, culturally Sustainability, sustainable and help us to satisfy our needs and wants. R ...
to another party wherein the second party does not reimburse the first party immediately (thereby generating a
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The de ...
), but promises either to repay or return those resources (or other materials of equal value) at a later date. In other words, credit is a method of making reciprocity formal,
legally Law is a set of rules that are created and are law enforcement, enforceable by social or governmental institutions to regulate behavior,Robertson, ''Crimes against humanity'', 90. with its precise definition a matter of longstanding debate. ...
enforceable, and extensible to a large group of unrelated people. The resources provided may be
financial Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption (economics) ...
(e.g. granting a
loan In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...
), or they may consist of goods or services (e.g. consumer credit). Credit encompasses any form of deferred payment. Credit is extended by a
creditor A creditor or lender is a Party (law), party (e.g., person, organization, company, or government) that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided s ...
, also known as a
lender A creditor or lender is a party A party is a gathering of people who have been invited by a Hospitality, host for the purposes of socializing, conversation, recreation, or as part of a festival or other commemoration or celebration of a ...
, to a
debtor A debtor or debitor is a legal entity, legal entity (legal person) that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counter ...
, also known as a
borrower A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or seri ...
.


Etymology

The term "credit" was first used in English in the 1520s. The term came "from Middle French crédit (15c.) "belief, trust," from Italian credito, from Latin creditum "a loan, thing entrusted to another," from past participle of credere "to trust, entrust, believe". The commercial meaning of "credit" "was the original one in English (creditor is
rom Rom, or ROM may refer to: Biomechanics and medicine * Risk of mortality The risk of mortality (ROM) provides a medical classification to estimate the likelihood of inhospital death for a patient. The ROM classes are minor, moderate, major, and e ...
mid-15c.)" The derivative expression "
credit union A credit union, a type of financial institution similar to a commercial bank, is a member-owned nonprofit organization, nonprofit financial cooperative. Credit unions generally provide services to members similar to retail banks, including depo ...
" was first used in 1881 in American English; the expression "
credit rating A credit rating is an evaluation of the credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal an ...
" was first used in 1958.


History

Credit cards became most prominent during the 1900s. Larger companies began creating chains with other companies and used a credit card as a way to make payments to any of these companies. The companies charged the cardholder a certain annual fee and chose their billing methods while each participating company was charged a percentage of total billings. This led to the creating of credit cards on behalf of banks around the world. Some other first bank-issued credit cards include
Bank of America The Bank of America Corporation (often abbreviated BofA or BoA) is an American multinational investment banking, investment bank and financial services holding company headquartered at the Bank of America Corporate Center in Charlotte, North ...
's Bank Americard in 1958 and
American Express American Express Company (Amex) is an American multinational corporation, multinational corporation specialized in payment card industry, payment card services headquartered at 200 Vesey Street in the Battery Park City neighborhood of Lower Man ...
' American Express Card also in 1958. These worked similarly to the company-issued credit cards; however, they expanded purchasing power to almost any service and they allowed a consumer to accumulate
revolving credit Revolving credit is a type of Credit (finance), credit that does not have a fixed number of payments, in contrast to installment credit. Credit cards are an example of revolving credit used by consumers. Corporate revolving credit facilities are t ...
. Revolving credit was a means to pay off a balance at a later date while incurring a finance charge for the balance.


Discrimination

Until the
Equal Credit Opportunity Act The Equal Credit Opportunity Act (ECOA) is a United States law (codified at et seq.), enacted 28 October 1974, that makes it unlawful for any creditor to discriminate against any applicant, with respect to any aspect of a credit transaction, on ...
in 1974, women in America were given credit cards under stricter terms, or not at all. It could be hard for a woman to buy a house without a male co-signer. In the past, even when not explicitly barred from them, people of color were often unable to get credit to buy a house in white neighborhoods.


Bank-issued credit

Bank-issued credit makes up the largest proportion of credit in existence. The traditional view of banks as intermediaries between savers and borrowers is incorrect. Modern banking is about credit creation. Credit is made up of two parts, the credit (
money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
) and its corresponding
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The de ...
, which requires repayment with
interest In finance and economics, interest is payment from a debtor, borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is ...
. The majority (97% as of December 2013) of the money in the UK economy is created as credit. When a bank issues credit (i.e. makes a loan), it writes a negative entry in to the liabilities column of its balance sheet, and an equivalent positive figure on the assets column; the asset being the loan repayment income stream (plus interest) from a credit-worthy individual. When the debt is fully repaid, the credit and debt are canceled, and the money disappears from the economy. Meanwhile, the debtor receives a positive cash balance (which is used to purchase something like a house), but also an equivalent negative liability to be repaid to the bank over the duration. Most of the credit created goes into the purchase of land and property, creating inflation in those markets, which is a major driver of the
economic cycle Business cycles are intervals of Economic expansion, expansion followed by recession in economic activity. These changes have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are ...
. When a
bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Beca ...
creates credit, it effectively owes the money to itself. If a bank issues too much bad credit (those debtors who are unable to pay it back), the bank will become
insolvent In accounting, insolvency is the state of being unable to pay the debts, by a Natural person, person or company (debtor), at Maturity (finance), maturity; those in a state of insolvency are said to be ''insolvent''. There are two forms: Cash flow ...
; having more liabilities than assets. That the bank never had the money to lend in the first place is immaterial - the
banking license A banking licence is a legal prerequisite for a financial institution that wants to carry on a banking business. Under the laws of most jurisdictions, a business is not permitted to carry words like a ''bank'', ''insurance'', ''national'' in the ...
affords banks to create credit - what matters is that a bank's total assets are greater than its total liabilities and that it is holding sufficient liquid assets - such as cash - to meet its obligations to its debtors. If it fails to do this it risks
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debt ...
or banking license withdrawal. There are two main forms of private credit created by banks; unsecured (non-collateralized) credit such as consumer
credit card A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the credit card issuer, card issuer to pay them for the ...
s and small unsecured loans, and secured (collateralized) credit, typically secured against the item being purchased with the money (house, boat, car, etc.). To reduce their exposure to the risk of not getting their money back (credit default), banks will tend to issue large credit sums to those deemed credit-worthy, and also to require collateral; something of equivalent value to the loan, which will be passed to the bank if the debtor fails to meet the repayment terms of the loan. In this instance, the bank uses the sale of the collateral to reduce its liabilities. Examples of secured credit include consumer mortgages used to buy houses, boats, etc., and PCP (personal contract plan) credit agreements for automobile purchases. Movements of
financial capital Financial capital (also simply known as capital or equity in finance, accounting and economics) is any Economic resources, economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their produ ...
are normally dependent on either credit or equity transfers. The global credit market is three times the size of global equity. Credit is in turn dependent on the reputation or creditworthiness of the entity which takes responsibility for the funds. Credit is also traded in
financial market A financial market is a market (economics), market in which people trade financial Security (finance), securities and derivative (finance), derivatives at low transaction costs. Some of the securities include stocks and Bond (finance), bonds, ...
s. The purest form is the
credit default swap A credit default swap (CDS) is a Swap (finance), financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt Default (finance), default (by the debtor) or other credit event. That is, the seller of the ...
market, which is essentially a traded market in credit insurance. A credit default swap represents the price at which two parties exchange this
risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
the protection ''seller'' takes the risk of default of the credit in return for a payment, commonly denoted in
basis point A basis point (often abbreviated as bp, often pronounced as "bip" or "beep") is one hundredth of 1 percentage point. The related term '' permyriad'' means one hundredth of 1 percent. Changes of interest rates are often stated in basis points. If ...
s (one basis point is 1/100 of a
percent In mathematics, a percentage (from la, per centum, "by a hundred") is a number or ratio expressed as a fraction (mathematics), fraction of 100. It is often Denotation, denoted using the percent sign, "%", although the abbreviations "pct.", "p ...
) of the notional amount to be referenced, while the protection ''buyer'' pays this premium and in the case of default of the underlying (a loan, bond or other receivable), delivers this receivable to the protection seller and receives from the seller the paramount (that is, is made whole).


Types

There are many types of credit, including but not limited to bank credit,
commerce Commerce is the large-scale organized system of activities, functions, procedures and institutions directly and indirectly related to the exchange (buying and selling) of goods and services among two or more parties within local, regional, nation ...
, consumer credit, investment credit, international credit, and public credit.


Trade credit

In commercial
trade Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market (economics), market. An early form of trade, barter, s ...
, the term "
trade credit Trade credit is the loan extended by one trader to another when the goods and Service (economics), services are bought on credit. Trade credit facilitates the purchase of supplies without immediate payment. Trade credit is commonly used by busines ...
" refers to the approval of delayed payment for purchased goods. Credit is sometimes not granted to a buyer who has financial instability or difficulty. Companies frequently offer trade credit to their customers as part of terms of a purchase agreement. Organizations that offer credit to their customers frequently employ a credit manager.


Consumer credit

Consumer credit can be defined as "money, goods or services provided to an individual in the absence of immediate payment". Common forms of consumer credit include
credit card A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the credit card issuer, card issuer to pay them for the ...
s, store cards, motor vehicle finance, personal loans ( installment loans), consumer lines of credit, payday loans, retail loans (retail installment loans) and
mortgages A mortgage loan or simply mortgage (), in civil law (legal system), civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners ...
. This is a broad definition of consumer credit and corresponds with the Bank of England's definition of "Lending to individuals". Given the size and nature of the mortgage market, many observers classify mortgage lending as a separate category of personal borrowing, and consequently, residential mortgages are excluded from some definitions of consumer credit, such as the one adopted by the U.S. Federal Reserve. The cost of credit is the additional amount, over and above the amount borrowed, that the borrower has to pay. It includes
interest In finance and economics, interest is payment from a debtor, borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is ...
, arrangement fees and any other charges. Some costs are mandatory, required by the lender as an integral part of the credit agreement. Other costs, such as those for credit insurance, may be optional; the borrower chooses whether or not they are included as part of the agreement. Interest and other charges are presented in a variety of different ways, but under many legislative regimes lenders are required to quote all mandatory charges in the form of an annual percentage rate (APR). The goal of the APR calculation is to promote "truth in lending", to give potential borrowers a clear measure of the true cost of borrowing and to allow a comparison to be made between competing products. The APR is derived from the pattern of advances and repayments made during the agreement. Optional charges are usually not included in the APR calculation. Interest rates on loans to consumers, whether mortgages or credit cards are most commonly determined with reference to a
credit score A credit score is a numerical expression based on a level analysis of a person's credit files, to represent the creditworthiness of an individual. A credit score is primarily based on a credit report, information typically sourced from credit bu ...
. Calculated by private credit rating agencies or centralized
credit bureau A credit bureau is a data collection agency that gathers account information from various creditors and provides that information to a consumer reporting agency in the United States The United States of America (U.S.A. or USA), commonly k ...
s based on factors such as prior defaults, payment history, and available credit, individuals with higher credit scores have access to lower APRs than those with lower scores.


Statistics


See also


Notes


References

* Logemann, Jan, ed. (2012). ''The Development of Consumer Credit in Global Perspective: Business, Regulation, and Culture''. New York: Palgrave Macmillan. .


External links

* * {{Authority control Debt