Understand the Basics of Credit
Credit is a financial concept involving the access to funds. This can be applied to businesses and individuals alike.
These days, it is rare to be self-sufficient. Businesses and individuals buy resources and assets to meet their needs. So, in basic terms, if surplus cash funds are always available on-hand there would be no need for credit. More likely, it makes more financial sense to use cash more efficiently. Credit is used as a financial tool when a borrower leverages a small amount of money to attain something of larger value based on a promise to repay an amount at a later date.
A borrower is granted credit by an individual or entity referred to as a creditor. Credit is rarely free. A creditor charges the borrower a rate that is agreed upon in a loan agreement. If the funds are used to purchase assets, those assets often become collateral. Collateral represents the value of the loan, and it is deemed a secured loan. If a borrower defaults, does not repay the loan as agreed, the creditor has the right to the assets that were purchased with the borrowed funds. Unsecured loans have no collateral and are granted solely on the borrower’s ability to repay as agreed.
Assessment of the ability to pay is referred to as credit worthiness. Businesses typically are granted higher credit limits because they have higher income. Therefore this indicates a greater ability to repay loans as agreed.
Misuse of credit can lead to financial hardship and potential financial ruin. A high income should show a likelihood of repaying debt. But too much debt increases the risk that loans will not be repaid as agreed, known as becoming overextended. This is measured as a percentage of income and represented by a debt-to-income ratio. Creditors and lenders use this ratio to establish the cost of lending and are known as the cost of funds. Those having high debt-to-income ratios are often charged much higher rates than those with low ratios.
Uses of Credit:
Business uses of credit can include:
- Purchase of buildings and facilities
- Business assets such as tools, equipment, and/or inventory
- Improvements or repairs
Consumer uses of credit can include:
- Mortgage of home
- Investment property
- Auto loan
- Personal unsecured loan