Understanding Credit: Types, Purpose, and Importance

• Credit is an agreement where one party lends money, goods, or services to another, expecting payment later.
• Trust is the foundation of all credit agreements.
• A debtor-creditor relationship legally binds the receiving party to repay the lender based on agreed terms.

Types of Credit

• Consumer credit is offered to individual consumers by retail businesses.
• Business credit is offered to businesses by financial institutions or other companies.
• Trade credit involves a business extending a line of credit to another for short-term purchases.

Purpose of Credit

• Functions as a medium of exchange, enabling purchases now with later payment.
• It provides the ability to use goods/services while paying, facilitates costly purchases, and funds emergencies.
• Credit cards offer convenience over cash or checks.

Importance of Credit

• It provides additional buying power, supporting production and distribution.
• Credit sustains cash flow, driving economic growth.

Credit Types

• Closed-end credit is a loan for a fixed amount, repaid with interest by a specific date or schedule.
• Open-end credit allows borrowing up to a limit over time, with payments against the outstanding balance.

Closed-End Credit Details

• Interest is the fee paid for using credit.
• Loans often require collateral, which is property forfeited upon default, making it secured credit.
• Installment loans involve repaying a specific amount with interest in regular installments.
• The principal is the initial amount borrowed.
• Contracts specify the principal, interest rate, loan duration, and other agreement terms.
• Payments are fixed for each installment.

Amortization Table

• It details interest and principal amounts per payment, ensuring loan repayment in a set time.
• Monthly payments remain constant, but the allocation between interest and principal changes.
• Interest costs are highest at the start of the loan.
• The finance charge is the total cost of credit to the borrower.
• Interest rates vary based on the lender and collateral.

Open-End Credit Details

• It establishes a credit limit with a repayment schedule.
• Credit cards exemplify this type.
• Borrowers can repeatedly use and repay credit, making it a revolving account.
• Often unsecured, it relies on a signed agreement without collateral.
• It is also known as a line of credit.

Credit Terms

• Credit is not free
• The annual percentage rate (APR) is the annual cost of credit.
• Higher APRs mean higher finance charges.

Finance Charge Components

• Interest rate is a percentage of the borrowed amount.
• Fees cover application and processing costs.
• The APR includes all charges, aiding loan comparison.
• The Federal Truth in Lending Act mandates APR disclosure.

Cost Factors

• Factors that determine the total cost for credit usage include:
  • Interest rate
  • Amount of credit used
  • Length of payment period

Proprietary Credit Cards

• These cards can only be used at the issuing company's stores.
• Many large stores and gasoline companies offer them.

The Three C's of Credit

• Character: reflects current debt, payment history, and credit scores.
• Capacity: considers income regularity and employment history.
• Capital: assesses assets versus liabilities.

Credit Reports

• Creditors request these reports to evaluate creditworthiness.
• Credit reports document credit history and financial behavior.
• They detail the number and types of credit accounts, payment timeliness, outstanding debts, and available credit.

Consumer Credit Reports

• They are issued by credit bureaus, which collect and provide credit data for a fee.
• Three major national credit reporting agencies exist: Equifax, Experian, and TransUnion LLC.

Credit Score

• Credit scores numerically represent creditworthiness at a given time.
• Scores vary by credit bureau.
• A FICO score is a type of credit score developed by Fair Isaac Corporation.

FICO Score Ranges

• 300-579: Poor
• 580-669: Fair
• 670-739: Good
• 740-799: Very Good
• 800-850: Excellent

Credit Card Application Factors

• Key factors when applying for a credit card include:
  • APR
  • Minimum payment
  • Credit limit
  • Late fee
  • Finance charges

Credit Policy

• It consists of written guidelines for approving customers for credit.
• It sets credit limits and specifies repayment terms, interest rates, fees, and consequences for non-payment.

Rewards and Risks of Extending Credit

• Credit can generate sales and build customer loyalty.
• Credit risk is the potential for non-repayment.
• Cash flow refers to money movement into and out of a business.
• Accounts receivable lists entities that owe money to a company.
• An accounts receivable aging report tracks due dates and outstanding durations.
• A collection agency recovers past due bills for a fee.

Obtaining Business Credit

• The five C’s of banking are:
  • Cash flow
  • Capacity
  • Capital
  • Collateral
  • Conditions

Types of Business Credit

• Supplier financing, known as trade credit, enables businesses to acquire goods without immediate payment.
• Trade credit terms often span 30 or 60 days (n/30 or n/60), indicating the payment deadline from purchase date.
• The net amount is the total purchase cost minus returns.
• Bank financing includes business loans and lines of credit.
• A business loan is for a specific purpose.
• A line of credit provides accessible funds as needed.
• The Small Business Administration guarantees loans up to 80% by private lenders.