Credit is a person or entity deemed to have the ability to borrow money or value for a period of time whereas the lender believes the individual, or entity, will pay them back, in full at some point in time.
Credit is established when a person borrows money and agrees to pay it back. The money can be obtained through a bank or other institution, as well as through friends and family. There is usually a set agreement outlining a repayment schedule and setting the amount the individual will be charged for using the money (interest and fees). In most lending situations the borrower pays back more than was borrowed.
To whom would you extend credit?
The facilitator wants to borrow money from you. What information would you need before lending this person money?
The Five C’s of Credit:
Capital: The amount of money you have to finance your investment. Lenders will require that you contribute a certain percentage total of the investment. The amount of capital you contribute will also affect the interest rate you receive.
Capacity: Capacity is the ability to repay a loan in terms of regular income. Lender’s use a formula called “debt to income” ratio to determine if you have enough regular income to support monthly debt payments. (We will review debt to income ratios in a later section.)
Credit: Credit here refers to the experience of paying back what you have borrowed. Lenders use your credit report and score to understand your credit situation.
Collateral: Collateral is something you own that you pledge to the lender should you not pay back the money you have borrowed. In some cases, the object financed is the collateral, for example houses and cars.
Character: The likelihood that you will pay back the money you borrow. Since creditors do not know you personally, they use your credit report to determine your character.
Types of credit
Revolving Credit
A revolving credit arrangement allows you to borrow up to your credit limit without having to reapply each time you need cash. As you repay the money you have borrowed, it is available to be borrowed again. (Credit cards and home equity lines of credit)
Installment Credit
This type of credit allows you to borrow a set amount of money one time, for a specific purpose. The lender, in this case, sets up a repayment schedule.
The fees and interest rate are determined in advance by the lender and calculated into the repayment schedule. The principal and interest are repaid in equal installments at fixed intervals (usually every month). (Mortgages, Auto loans)
Secured Credit
This type of credit can be revolving or installment credit. In this type of credit arrangement, the lender will ask you to provide them with something of value
(collateral) as a promise to repay your debt.
Unsecured Credit
This type of credit can be revolving or installment credit. In this type of credit arrangement, the lender will loan you money without any guarantee of repayment outside of the repayment contract.
Traditional Credit
Creditors who offer this type of credit report to the credit bureaus on your payment status whether you are current with agreed upon payments or not.
Four types of credit are considered traditional credit: Auto loans, Mortgages, Student Loans and Credit Cards.
Alternative or Non-traditional Credit
Rent, utility payments, cell phones are forms of non-traditional credit. Non- traditional credit does not usually show up on a credit report, unless it is in default. However, it can be used to credit worthiness when an individual asks a landlord, utility companies, etc. for credit reference letters to present to prospective creditors. This will show their commitment to paying their bills.