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Credit is a financial instrument that allows people to borrow money by giving security over their future earnings. Credit can be extended to consumers, companies, and governments by putting up collateral. A person with access to credit has cash available to spend on goods and services. This cash can either come directly from the lender or indirectly through income generated from assets such as property or investments.
When someone takes out a bank loan or buys shares, they invest and receive interest. However, the borrower who uses credit to buy items like furniture, cars, houses, etc., is considered to be spending his funds since he takes out the loan or makes the purchase himself. In short, one spends his/her funds whether he wants to or not.
It is widely accepted that there are two types of credit; secured and unsecured. Secured credit involves providing a personal guarantee that if the debtor defaults on repayment, the creditor may sell the pledged asset(s) to recover the outstanding debt.
Unsecured credit enables the borrower to pay only the interest payments on the loan. The amount of time taken to repay the principal is known as the term of the loan and varies according to the type of loan. The longer the period, the higher the cost of the loan.
How Credit Works:
When a person applies for credit, he must understand the question, “what is credit” and provide the lending institution with details of his previous employment history and any other information that might influence the decision of whether the applicant should get the loan.
What Is It Good For:
The most obvious purpose for credit is to buy things you want or need when you don’t have enough liquid savings to cover all your needs.
- Financing business activities:
Businesses take out loans to finance new purchases or expansion plans. If the company can afford to do so, it will invest in plant and machinery. They typically extend more than one line of credit. The business owner signs promissory notes for each line of credit which obligates him to repay the sum lent at set dates and intervals.
At times, the terms of the note allow the business owner to defer payments until later. They may then apply this additional time to reduce the required payments.
- Personal finance:
Individuals often use credit cards or lines of credit to fund major purchases. For example, monthly installments are added to the existing balance when a car is purchased. The consumer pays off the full amount at the end of every month.
- Investing:
Money used to invest in stocks, bonds, mutual funds, or real estate is called “credit.” There are many different ways to invest. Some people prefer to invest in individual securities such as stocks, while others choose to put money into mutual funds.
- Debt Consolidation:
Many individuals need help with their installment agreements. One solution is to consolidate multiple debts under one agreement. Consolidation usually means paying less interest, but sometimes other benefits are involved. To qualify, applicants generally must show how much debt they owe and be able to prove that repaying the debt would help them improve their overall financial situation.
- Insurance:
Life insurance companies offer policies where the beneficiary receives regular payments for life coverage. These payments continue even after the insured dies. Companies offering these policies commonly require borrowers to pledge certain assets (automobiles and homes).
In exchange for the promise to make payments during retirement, the insurance company agrees to pay the beneficiary upon death.
- Mortgages:
Many people take out mortgages to add to the value of their homes. Often, the mortgage holder has the right to force the sale of the property if the borrower defaults on payment obligations. The bank collects the proceeds from the sale and uses them to offset the original debt.
