What is Credit?
Credit is a term that is commonly used in the accounting and financial world, and it comes with different meanings. The basic definition of credit is an agreement between a lender and a borrower, where the lender agrees to extend a certain sum of money to the borrower. The borrower, in return, agrees to repay the money at a future date with an interest on the outstanding balance.
Credit can also refer to the creditworthiness of a borrower, which is the ability to pay back the credit extended by the due date. When extending credit to individual and corporate borrowers, lenders advance credit based on their confidence that the borrower will pay back what they borrowed plus the interest charged on the credit.
In accounting, the term “credit” can be used to refer to an accounting entry that decreases assets or increases liabilities in the balance sheet.
How Credit Works
The concept of credit was first used in the 1520s. Before extending credit facilities to borrowers, creditors in the ancient times assessed the creditworthiness of a potential borrower on reputation alone. The concept was not as advanced as it is today, and traders made lending decisions based on their personal opinions and beliefs about the borrower. Such a method was subjective, and therefore, prone to bias and manipulation and would lock out potentially credible borrowers.
Nowadays, the process of assessing the creditworthiness of a potential borrower involves a more objective approach, compared to a subjective approach in the past. Rather than relying on opinions and personal beliefs, creditors now evaluate the credit history of a borrower by looking at their credit report, which is obtained from credit bureaus.
The credit report shows the amount of credit that the borrower has borrowed for the past one to seven years, how much they have paid, the timeliness of repayments, history of defaults, history of auctions or foreclosures, etc. Credit bureaus also provide a credit score based on a borrower’s credit history, and lenders rely on this information to determine whether or not to extend credit.
Types of Credit
The following are the main types of credit:
1. Bank credit
Bank credit refers to the total amount of credit available to an individual or corporate borrower from a financial institution. The amount of credit that a financial institution holds at any time depends on the total amount of combined funds available in the institution, as well as the borrower’s ability to repay the loan.
The credit granted by the bank can be used to finance the purchase of an asset, such as a house or motor vehicle, or to fund working capital. Once the credit is provided to a borrower, the bank requires a fixed monthly repayment for an agreed period of time.
There are two main types of bank credit, i.e., secured credit and unsecured credit. Secured credit is a credit that is backed by an asset such as a motor vehicle, farm machinery, or house, which acts as collateral for the loan. The lender places a lien on the asset pledged as collateral, and the borrower never fully owns the asset tied to the credit until he/she has fully paid up the debt. In the case of borrower default, the lender is at liberty to seize the asset pledged as collateral to recoup the losses incurred.
On the other hand, unsecured credit is not backed by any collateral, and the lender cannot claim any of the borrower’s assets to force repayment. However, unsecured credit lenders can still resort to other means to enforce collection. For example, they can hire a debt collection agency or report the non-payment to credit bureaus.
2. Trade credit
Trade credit is a form credit that allows a customer to purchase goods from a seller with an agreement to pay the purchase price at an agreed future date. Most companies often provide trade credit as part of the terms of a purchase agreement. However, customers that benefit from this arrangement must be financially stable and with a history of paying back credit on time.
Businesses that offer trade credit terms allow a 30-day, 60-day, or 90-day repayment period, and the transaction is captured in an invoice. Some customers can negotiate a longer trade credit repayment period, and the approval of such terms depend on the seller’s criteria for qualifying trade credit transactions.
3. Consumer credit
Consumer credit is defined as a form of personal credit where an individual purchases goods or services without immediate payment. Some common examples of consumer credit include credit cards, payday loans, retail loans, etc. Consumer credit is provided by banks, credit unions, and retailers, and the borrowers are required to pay off the debt over time with interest.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: