Understanding Credit in Economics

• Credit is the ability to obtain valuable items in exchange for a promise to pay at a future date, from the debtor's perspective.
• Credit is also the willingness to accept the debtor’s promise based on trust and confidence, from the creditor’s perspective.

Significance of Credit

• Credit plays a vital role in the modern economy, influencing communities, lifestyles, and living standards.
• Credit impacts the political, economic, and social aspects of life, enhancing the functions of regular exchanges when properly utilized.
• Credit enables increased production of goods by facilitating business expansion when profitable market opportunities are anticipated.
• Credit facilitates the distribution of goods by providing financial resources to businesses for both domestic and foreign market ventures.
• Credit is important for promoting full employment through increased production, reliant on market expectations and consumer ability to fulfill desires.
• Consumer credit acts as a connection between production and distribution, enabling consumers to purchase beyond their immediate means.

Elements of Credit

• Trust is a fundamental element, derived from the word "creditum," signifying confidence in the borrower.
• Futurity, or time, distinguishes credit transactions from cash transactions, involving payment after a specified period.
• Risk is inherent due to reliance on the debtor's future performance and the uncertainty of full or timely payment.

Characteristics of Credit

• Credit is a bilateral contract involving a debtor and a creditor, with the creditor entrusting goods or services to the debtor based on a promise of future payment.
• Credit is a personal contract, primarily based on trust in the debtor's character and their ability to repay.
• Credit is a pecuniary contract, requiring clear understanding of the exact amount of obligations and claims measured through a standard of deferred payments, i.e., money.

Cases Where Credit Transactions Arise

• Deferred payments for goods and services.
• Money loans.
• Services rendered with wages or salaries received after the service, or sometimes in advance.

Advantages of Credit

• Credit allows immediate access to goods and services without immediate payment.
• Credit cards offer shopping convenience without carrying large amounts of cash.
• Credit provides temporary solutions for unexpected financial difficulties.
• Credit serves as an agent of production by channeling idle funds into productive activities.
• Credit enhances wealth fluidity by turning fixed assets into current assets through secured loans.
• Credit supplements the monetary system by providing alternative exchange mediums like checks.

Disadvantages of Credit

• Credit costs money because purchases paid over time incur additional expenses.
• Credit encourages overspending and impulsive buying.
• Credit ties up future income, reducing disposable funds.
• Credit may result in losses, including merchandise or collateral, if payments are not made on time.
• Liberal credit can lead to over-expansion or over-speculation during economic booms, increasing vulnerability during downturns.
• Heavy government borrowing may lead to cuts in essential projects when needed most.

Classifications and Kinds of Credit

• As to Maturity:
  • Time Loan: Payable on a definite maturity date.
    • Short-term: Payable within one year.
    • Medium-term: Payable in one to five years.
    • Long-term: Payable in more than five years.
  • Call/Demand Loan: Payable upon demand with indefinite maturity.
• As to Source:
  • Public: Granted by government institutions.
  • Private: Granted by commercial enterprises, banks, and other financial institutions.
• As to Payment of Interest:
  • Ordinary: Interest is paid with the principal at maturity.
  • Discount: Interest is deducted from the principal when granted.
• As to Method of Release/Repayment:
  • Lump-sum: The principal is given once to the debtor/the principal is paid in full.
  • Installment: The principal is broken down in staggered releases/repayments.
• As to Source of Repayment:
  • Self-liquidating: Repayment comes from the income derived from the use of the principal.
  • Non-self-liquidating: Repayment comes from the personal income (salary) of the debtor.
• As to Purpose:
  • Agricultural: Used for agricultural needs like irrigation, seeds, and fertilizers.
  • Commercial: Used for short-term working capital needs, such as payments and inventory purchases.
  • Industrial: Used for long-term capital needs, such as expansion and fixed asset acquisition.
  • Real Estate: Used to finance real estate acquisition and improvement.
  • Personal or Consumer: Used to facilitate consumption of goods and services.
• As to Security:
  • Secured: Credit issued with collateral.
  • Unsecured: Credit issued without collateral, also known as a character or clean loan.

Loan Considerations

• Purpose: Loan should be for productive use to ensure repayment and contribute to economic development.
• Type and Size: Diversify loan portfolio to spread risks, considering that larger amounts involve greater risk.
• Maturity: Match loan maturity to the duration of financing needed by the borrower.
• Security: Require collaterals such as real estate, stocks, machinery, and inventories to reduce lending risks.
• Interest: Set rates considering the cost of funds and the lender-borrower relationship.
• Loan Liquidation: Discuss repayment thoroughly to avoid future issues and maintain the lender's liquidity.

The Ten Commandments of Credit: The Cs of Good and Bad Loans

• The Five Cs of Good Loans: Represent the "Thou Shall" commandments of lending, consisting of character, capacity, conditions, capital and collateral.
• Character: Refers to the borrower’s payment habits and attitudes, that is, his willingness to pay.
  • Thou shalt make sure that the company or person you are lending to is of outstanding character.
• Capacity: Refers to the borrower’s ability to pay as reflected in his cash flows.
  • Thou shalt be sure that the company or person you are lending to has the capacity to repay the loan.
• Capital: Refers to the borrower’s net worth position relative to his outstanding debts.
  • Thou shalt make sure that the borrower is adequately capitalized.
• Collateral: Refers to any asset which may be pledged against the debt.
  • Thou shalt make sure that collateral does not drive lending decisions.
• Conditions: Refers to economic factors which may affect the borrower’s line of work or industry and how changing economic conditions might affect the loan
  • Thou shalt underwrite all loans understanding that business and economic conditions can and will change.

The Five Cs of Bad Credit

• Represent the "Thou Shalt Nots," to guard against complacency, carelessness, communication, contingencies, and competition.

• Complacency: Guard against overconfidence, overemphasis on past performance, or reliance on large net worth.

• Carelessness: Prevent inadequate loan documentation, lack of current financial information, lack of protective loan covenants, and failure to keep information in files.

• Communication: Ensure clear credit quality objectives and upward communication from the front line; regulators must communicate concerns early and consistently.

• Contingencies: Weigh the risks of a loan, considering all potential negative events and their likelihood.

• Competition: Avoid making decisions based on what other lenders are doing; be careful of competitive euphoria and prioritize loan characteristics over winning business.