DEFINITION: The term “credit” has a variety of meanings in the field of business and finance. Nevertheless, two central meanings of the term are clear enough:
First, the term may refer to the ease with which an individual or company is able to borrow money or other valuable assets from a lending institution. A synonym for this sense of the term is “creditworthiness.”
In this sense, one commonly speaks of individuals and companies as having “good credit” or “bad credit,” as the case may be.
Second, the term may also refer to money that is owed to an individual or company by others. In this sense, it is the opposite of the term “debit”—money that an individual or company owes to others.
In the domain of accounting, this sense of the term indicates a particular type of bookkeeping transaction.
ETYMOLOGY: The English word “credit” is attested from the sixteenth century. It derives from Middle French, Old Italian, and, ultimately, from the Latin neuter past participle, creditum, of the verb credo, credere (“to trust in,” “to rely upon,” “to give credence to,” “to believe”).
The word is also closely related to the Middle English crede and Old English crēda, both meaning “creed,” also from the Latin verb creo, credere,
USAGE: Credit in the sense of creditworthiness depends upon an individual or company’s state of financial health and reputation for prudent behavior.
Such a financial state of health and reputation for prudence make it likely that any principal amount of money a company or individual may borrow will be repaid in a timely manner, along with interest charges.
That is why creditworthiness makes an individual or company an attractive prospective borrower to lending institutions. It is the primary basis upon which the lender may determine that the borrower will repay his loan in a timely fashion.
Credit in this sense represents an agreement between a lender (the “creditor”!) and a borrower (the debtor). The debtor promises to repay the lender, often with interest, within a given period of time.
Therefore, loosely speaking, “credit” is a short-hand way of referring to the overall practice of lending/borrowing—a human practice that goes back thousands of years.
Different Kinds of Credit
Different kinds of credit exist. Some familiar examples include car loans, home mortgages, personal loans, and lines of credit.
Perhaps the most significant and widespread form of credit in contemporary American society is credit cards, which basically grant consumers the ability to purchase almost any item “on credit,” that is, with just a signature, constituting a promise to repay the loan according to the terms of the original credit card agreement.
Credit card transactions are unique in that the card-issuing bank acts as an intermediary between the buyer and the seller of the merchandise purchased. The bank pays the seller in full immediately, while accepting repayment from the buyer—the credit card holder. As with any other type of loan, the bank makes its profit from the interest it charges on the principal amount of the money it lends.
Similarly, the notion of credit extends to situations in which a buyer receives products or services from a seller without having to make an immediate payment.
In such cases, by extending credit to its clients, the seller of a product is acting in the manner of a bank. However, the seller’s motivation in such cases is typically not to earn interest, but rather to accommodate the wishes of its valued customers.
Credit Scores
Credit scores serve as a means of categorizing individuals or companies according to the degree of their creditworthiness.
With respect to individuals, such scores are valued not only by banks and other prospective lenders, but also by landlords, insurance companies, and even prospective employers.
With respect to companies, credit-rating agencies (such as Moody’s and Standard and Poor’s) assign letter-grade scores that reflect the companies’ creditworthiness (financial health).
Such scores are closely monitored by bond investors. They also may influence the interest rates that companies need to offer when borrowing money.
Moreover, such scores may even affect the pricing of bonds and other securities issued by governmental entities, based on the creditworthiness of the issuing body.
Credit Instruments
Letter of Credit: A bank-issued document frequently employed in international trade. A letter of credit assures a seller to which it is presented that he will receive full payment for the debt incurred by the holder of the letter (buyer). If the buyer fails to pay his debt to the seller, the bank pays the seller in his stead (and pursues its claim against the buyer by legal means).
Line of credit: A loan provided by a bank or other financial institution granting the borrower access to a specific amount of credit that can be drawn on as needed, as opposed to receiving the entire sum at once.
Credit Limit: The maximum amount or ceiling of a line of credit that a lender, like a credit card company, is willing to offer to a borrower. The most common example is the dollar limit that the issuing bank puts on the amount that an individual can spend using his credit card.
Revolving credit: A loan with no fixed end date. A credit card account is the most common example of revolving credit. So long as the account remains in good standing, the borrower can continue to borrow against it, up to whatever credit limit has been established.
As the borrower makes payments, the remaining balance owing declines, thus replenishing the amount available for use. These kinds of loans are often referred to open-end credit.
Home mortgages and automobile loans, on the other hand, are examples of closed-end credit because they must be paid completely by a date certain.