What is credit? How it works | Financial Greedy

What is credit?

The term “credit” has various meanings in the financial market, but most of the time it is used in borrowing or lending, where the borrower receives money or goods and promises to pay them later, with interest.

The other commonly used definition is the credit score or history of an individual or a company, whereas in the accounting world, it is a special type of bookkeeping entry.

Credit

How it works

“Credit” refers to the later payment of any kind of purchase through the use of a legal contract.

When a loan is taken from a bank or financial institution, a formal agreement is signed between the two parties. It can be called a loan contract agreement or promissory note.

The agreement should clarify the terms and conditions, such as interest rate, loan repayment, collateral, if any, and other factors related to both parties. In every situation, this agreement binds it legally.

In the case of trade, the transaction is consummated using a purchase order (PO), in which the buyer agrees to legally purchase goods or services from the seller. After the delivery, the purchase order is fulfilled, and a payment invoice is issued by the seller to the buyer. This loan agreement includes terms and conditions like due dates, penalties, etc.

5 Cs of Credit

‘Credit’ consists of five Cs, and each of them will be discussed in specific detail:

Character

Character tends to be a very broad concept, although it is subjective sometimes. It evaluates “creditworthiness.” The statement is that borrowing history, loan management, and payments should serve as proxy for future creditworthiness.

For a single person, it could be assessing what type of “person” they are by learning about their credit history.

The process for a corporate borrower is much more complex, mainly if it’s a private company that recently came into a lending institution. Officers from the loan department will try to understand the business through its reputation and credibility.

Capacity

Capacity refers to the borrower’s ability to service debt conditions in the future. The ability of the borrower, whether it is a personal or corporate company, is determined through various measuring methods like total debt service (TDS) or debt service coverage (DSC).

Evaluating capacity requires a loan giver to understand the borrower’s ability to fulfil their total obligations, not just their current request.

For business lenders, understanding a borrower’s competitive advantage sources also had to be evaluated since they can greatly impact the borrower’s ability to maintain price, margins, and cash flow.

Capital

In the minds of some people, capital can be the borrower’s overall monetary strength, but in reality, what other assets will support the debt repayment if all cash sources end up dry?

A personal borrower can sell marketable securities or property assets if no cash is available.

Businessmen or commercial borrowers are only provided loans by the lender if the company is under-leveraged. In situations where a company is over-leveraged, the chances of loan acceptance are low.

Collateral

Collateral refers to an asset that is legally pledged to the lender as protection in case the borrower is unable to pay back the loan. What type of collateral is provided depends on the type of senior secured lender, and understanding it is very essential.

Collateral security is very important in cases of liability risk. After all, in certain cases where loan repayment is not possible, the collateral will cover the loan payment.

The quality, condition, and overall features of the collateral impact the loan-to-value (LTV) that can be provided by the lender.

Conditions

The terms and conditions under credit are like a broad umbrella but are very important for the agreement. They include the purpose of the fund that is requested. It also includes many external factors as well as risks and opportunities.

To understand the merits and demerits of a borrowing request, many aspects should be considered, like our position in the economic cycle, political or technological risks that may occur in the borrower’s cash flow, and other related queries.

How do consumer and business credit affect each other?

Economy

The monthly credit use is measured by economists because it is an indicator of contraction. If consumers are borrowing willingly and can pay it back later, then the economy receives a boost.

What is the impact of consumer credit on the national economy?

Business

It is a very important part of present-day businesses, as most of the payments are done through electronic cards. A well-reputable company must provide consumers with electronic card services.

Why is a credit score important for a business?

What can be considered a good score?

According to the FICO scoring model, there are five categories of credit scores:

• Poor: 300-579
• Fair: 580-669
• Good: 670-739
• Very Good: 740–799
• Excellent: 800-850

The good score ranges from 670 to 739, although many consider a FICO score higher than 670 to be “good credit.”

This means that coming under “excellent” or “perfect” automatically makes your score “good credit.”

With a score higher than 670, you have moved from the “subprime” category to the ‘prime’ category. Only people who fall into the prime category are able to receive all kinds of benefits.

Why do I need a good credit score?

Along with a good assessment, a number of benefits are available. For example, renting an apartment, getting a job, getting loan approval, etc. are some of the benefits that come with a good credit score. Some other advantages are:

• Easier Approval

The most important advantage provided by a better score is that bank applications like electronic cards, loans, or mortgages will be easily accepted, consuming less time.

• Lower interest rates

A higher score can lead to lower interest rates, which can be beneficial to small businesses. A large amount of money can be saved, which could be useful for businesses in the future.

• Better Loan Terms

A good score means good loan terms. In some cases, you might be able to receive a higher card limit on your electronic cards.

Credit Card Processing Services for Small Businesses in 2023

Factors Affecting the Credit Score

There are about five factors that influence the scoring system. These attributes are:

1: Payment History: 35%

2: Amount Owed: 30%

3: Length of Credit History: 15%

4: New Credits: 10%

5: Kinds of Credits In Use: 10%

Top 5 Factors That Affect Your Credit Score

5 best ways to build up a credit score

1: Build your credit history.

With little or no history, it becomes hard for companies to assess you, which will result in a low score. This is a well-known hurdle among the young generation, but by following a few steps, you can build up your history.

2: Make regular payments.

Early card payments every month are a good way to show your diligence and reliability to the lenders. It will show you responsibly handle your finances and old accounts, which can contribute to the building up of your credit score.

3: Monitor your file for fraudulent transactions.

Hackers can easily gain access to your files and take actions in your name. This can ruin not only your score but also your business or private life. Therefore, regular checkups should be made related to any suspicious activities on your accounts.

4: Keep old accounts

Instead of closing down your old accounts after you don’t use them anymore, it’s better to keep the accounts, as they have a long and well-built history that could be useful to show to creditors for loan approval.

5: Less Utilisation

It is considered positive to spend only 30% of your card limit. For example, if you have a limit of $1000, spending $300 will be seen as more positive by creditors than spending $500. It means you should try to keep your spending as low as 30%.

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