Credit is a type of financial borrowing where money is advanced to a borrower by a lender who expects to be repaid, plus other charges for using the funds. Credit may decrease assets, increase liabilities, decrease expenses, or increase revenue. Credit is a loan feature of the financial cycle.
Credit terms for a loan specify the duration of the loan and may include interest, a grace period, and other fees. Many people may be asking what is credit because they need a clearer understanding; therefore, they misuse money by taking loans and other types of credit.
Credit is the primary tool that individuals use to manage their economy, and the main reason countries have currencies. Here are different forms of credit that we use daily in life.
- Debt/Liability Credit
These are usually secured loans (i.e., collateralized with an encumbrance on collateral) where the creditor is not obligated to advance funds until the contractual obligation is satisfied. The cost of debt financing can be spread over time by utilizing interest accrual or amortization methods.
Businesses, governments, and individuals usually undertake debt credit to purchase assets or meet liabilities arising from natural business processes or government development projects. When the loan is repaid, the amount of debt outstanding goes down. If the amount of debt is fully refunded, the debtor becomes credit free.
- Equity Credit
These are unsecured loans. The creditor has the right to go after the debtor’s assets if they default on payment. The creditor has the right to seize its debtor’s property in case of bankruptcy. Equity loans are usually not offered to individuals but only to institutions such as corporations, partnerships, or limited liability companies.
The aim is to raise the short-term capital needed to finance a project, a new business, or an expansion. When the debt is repaid, the number of equity increases. If the debt amount is fully refunded, the debtor becomes credit free.
- Mortgage Credit
These are secured loans (i.e., saddled with a mortgage) that are usually offered to individuals, who then use the money for purposes such as home ownership and to purchase other assets. The debtor is only released from their obligation to pay when the creditor receives full payment.
The debtor’s collateral may be sold to satisfy creditors if they default on payments. Mortgages are usually repaid by drawing down equity in the property or selling it at a later date.
- Savings Credit
These loans are the direct opposite of debt credit. Savings credit is financed by a lender that, unlike a creditor, lends to the debtor without extending principal or interest payments over time.
The aim is for the debtor to save a portion of their income to buy assets or meet other liabilities as and when they arise, plus pay off the savings credit. Banks usually offer savings credit. When repaid, savings credit decreases and the debtor becomes credit free if fully refunded.
- Business Credit
These are secured loans generally offered to small businesses by banks, finance companies, commercial banks, or other lenders. Business credit can be used to purchase capital assets or to meet other liabilities arising from natural processes in the business (e.g., taxes).
The aim is for the debtor to pay regularly so that the amount of business credit outstanding can be reduced and eventually repaid. The amount of business credit due goes down when the debt is repaid.
Credit has a significant role in modern life. Without credit, businesses would be stagnant and unable to expand. As we advance, the importance of credit will continue to grow as we move into a global economy.
Understanding what credit is will assist in adequately using this crucial economic tool to your advantage.