What is credit?

what credit credit problems

What is credit?

Credit is money a creditor or lender makes available for you to borrow with a deferred repayment. In exchange for the credit, the lender gets back the money, usually paid on a monthly basis, plus interest. The debtor gets the use of the money to pay for and take possession of goods and services immediately. Modern society is dependent upon credit to generate sales; it enables people to have the things they want and need, but can’t afford to pay for right away.

Interest is the compensation that the creditor demands for the use of his/her money. Money has a “time value” to it. Over time the value of money decreases (due to inflation): what a dollar will buy today is much less than what a dollar could purchase 20 years ago. Since a creditor pays out money today in exchange for a repayment of it in the future, the creditor loses the time value of that money. In order to make credit available, creditors are allowed to charge interest, often referred to as a finance charge. For example, if a lender gives you $10 worth of credit, s/he might expect to be repaid $11 within the next two months; the extra dollar is the interest charged for the loan.

Interest on credit can be either simple or compound.

Simple interest is interest charged only on the principal amount borrowed. Simple interest does not add the interest charge back to the outstanding loan during the length of the loan. Compound interest is interest charged not only on the principal, but on the interest accrued during the length of the loan. Thus, simple interest charges are less than compound interest charges.

Credit is extended pursuant to a written contract. The written contract sets forth the respective rights and responsibilities of the creditor and the debtor. Credit can be used by both businesses and individuals. When an individual uses credit, it is referred to as “consumer credit.”

(Reviewed 11.3.08)

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