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Understanding Credit in Economics

Updated on September 8, 2009

Credit, in economics and finance, refers to the faith that a creditor (lender) places in a debtor (borrower) by extending him a loan (the word credit is derived from a Latin base meaning "faith" or "trust"). In a modern market economy the loan is usually in the form of money. When a loan is made, the lender extends credit to the borrower, while at the same time accepting the credit of the borrower. Credit performs two primary functions: (1) it facilitates the transfer of capital or money, thereby increasing the productivity of capital by placing it where it will be most effectively and efficiently used; and (2) it economizes on the use of paper currency and coins.

A market economy, such as exists in the United States, could not function without extensive use of credit based almost exclusively upon the faith and trust of the participating buyers and sellers. In addition, the existence of readily salable commodities or collateral in the hands of the borrower tends to increase the amount of credit that may be extended to him by adding to his means of repayment.

Credit is also extended to purchasers by sellers when payment for goods or services is deferred or postponed, with or without interest charges. Consumer credit may be granted to households through charge accounts, deferred payment plans offered by sellers, or credit cards. To obtain funds needed currently, the seller frequently discounts his accounts receivable with a bank or commercial credit firm.

Purchases by business commonly involve trade credit; payments are deferred for a specified time (frequently 30 days) with no interest charge. Then an interest or carrying charge is levied on the unpaid balance. Fast payment is often encouraged by offering a discount if the bill is paid promptly (for example, 2% discount for payment within 10 days). Business accounts receivable are also discounted with banks or sold to specialized credit organizations known as factors.

Charge accounts, credit cards, seller installment credit, and trade credit all differ from direct lending since no funds are advanced when the credit is extended. The purchaser's credit is the basis for postponing payment.

Credit System

A highly developed credit system is necessary for the widespread use of credit. The credit system facilitates the transfer of credit instruments and the extension of credit. Credit instruments take such forms as promissory notes, bonds, and bills of exchange. A check is a specialized type of bill of exchange. To perform their function of transferring credit adequately, credit instruments must be fully and readily negotiable. Negotiability depends on acceptability, and acceptability in turn depends on the faith that constitutes the ultimate basis of credit.

An actual loan need not be made for credit to be utilized in economic activity. Credit supplies the modern world with the bulk of its media of payment, or money. Bank demand deposits or checking accounts constitute the largest segment of the money supply of the United States, and over 90% of the dollar volume of money payments in the United States is accounted for by checks. Checking account deposits are simply liabilities of commercial banks, and only the universal acceptability of bank credit permits them to function as money. In addition, virtually all of the paper money in the United States, which comprises all but a negligible portion of the total currency in circulation, is credit money. Each bill is simply a promise to pay by the United States government or by one of the Federal Reserve banks. The faith of the general public in the ability of the issuer to make good its promise on demand is the foundation of the bulk of the money supply in the United States.

Bank Credit

Bank credit is a peculiar feature of a highly organized market economy. Because commercial banks serve as clearinghouses for the financial transactions of many persons and businesses, the credit of a bank is accepted in many instances where the credit of an individual or private business would not be accepted. A commercial bank can also create credit, and hence money. When a commercial bank lends money, it sets up a checking account in the name of the borrower for the amount of the loan, thereby substituting its own credit for that of the borrower. The important difference is that commercial bank credit is more generally acceptable and functions as money.

Credit Rating

A borrower's or purchaser's ability to obtain credit depends on his credit rating. This considers his income, his job stability, his family obligations, his current outstanding debts, and his record of satisfying his debts promptly. Lenders and sellers often share such information with credit rating bureaus. An individual's credit rating is a combination of his apparent ability to carry the burden of new debt and his indicated past willingness to meet his obligations. An individual's credit rating influences the terms of any credit he may obtain, how much will be extended, and whether he will be granted any credit at all.

Credit Institutions

Several types of credit institutions have developed to accommodate specific borrower or purchaser needs. Commercial banks offer the widest range of lending services. They are primarily lenders on short-term commercial credit, but they also make term loans to business, personal loans, mortgage loans, and consumer installment loans. Mutual savings banks and savings and loan associations are primarily mortgage lenders. Credit unions and small loan companies make personal loans (secured and unsecured). Banks, commercial credit firms, and factors lend on accounts receivable; sometimes they purchase receivables outright. This specialization has further expanded the use of credit in the United States, with the result that greater development of organized markets and of large-scale enterprise has been possible.

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    • The Rope profile image

      The Rope 7 years ago from SE US

      It's great information and presented in a concise manner. Wishing you well - we're all trying to learn.