What is Credit? Definition, Types and Examples

There are so many times that we want to buy something, but the cash we have on hand or in our bank account is not enough. It may be a new car, paying for school fees, going on a holiday, expanding your business, or anything else. While we can delay or avoid buying luxury items, what about things we need and cannot do without? In such situations, getting a loan is the answer for most of us. I remember, a few years ago, I needed to buy a new bike and did not have enough money to buy it. So, I took money on a loan from a bank and purchased the bike on credit. It made my commute to the office easier and running my daily errands quicker. Most of us rely on loans and credits to help manage our finances.

What is Credit?

When a bank or any financial institution lends money to customers for any purpose, it is known as credit. If you are wondering what credit is, it simply means being able to get a loan from a lender to purchase anything and repay the money after some time. Credit provides the means and flexibility to purchase today and pay later, and there are many types of credit that you can choose from.

How does Credit Work?

Credit is the simple process of taking a loan today and repaying it later, with interest. When you take a loan from any bank or financial institution to buy any goods or services, you are borrowing the money on credit. You use the credit to fulfil your goal and then repay the money to the lender along with interest on the principal amount. Purchasing on credit also builds your credit history, which is a record of all your loans and repayment schedules. Having a good credit history will help you get your next loan easily. If you do not repay the loan on time, your credit score will be reduced.

Why do you Need Credit?

All of us need credit from time to time for various reasons:

• Any type of credit is needed to purchase various assets, goods, and services, such as a car, renovating a house, or buying a new phone.
• Credit is also needed to pay off older loans or bigger bills.
• You require credit to obtain a good credit score, as lenders sanction your loans based on your credit score and history. A good credit history ensures the lender that you will repay the loan on time.
• With a good credit score, you can also obtain a new loan at a lower interest rate and better terms and conditions.

Types of Credit

There are 3 main types of credit, and we will discuss each one in detail.

1. Revolving Credit

   All of us use revolving credit, but without calling it that, think of your credit card. It is a type of credit where you have a set limit, up to which you can access the funds at any time. As long as your credit account is open, you can borrow from it or repay it at any time. Most of the time, when your credit score is good, the lender will increase your credit limit.

   In revolving credit, you can use all the available credit at a go or some of it, as per your requirement. You also have the flexibility to pay it back, either with one payment or in instalments. But, most of the time, you will need to make minimum payments from time to time to keep your account in good standing. The lender most often charges interest on a variable rate on the balance owed in revolving credit.

   Examples of Revolving Credit:
   • Credit Cards: A typical credit card offers a line of credit set to a limit, up to which you can use it at any time to buy anything or pay bills. You can either pay the lender in monthly cycles or later, but if you delay payment of credit card dues, you will have to pay more interest.
   • Home Equity Lines of Credit: When you take out a home equity line of credit, you borrow money against the value of your home. Your house acts as collateral for the loan.
   • Personal Lines of Credit: A personal line of credit has a set credit limit. You can access the funds and repay them anytime during the loan's duration.

2. Instalment Credit

   In instalment credit, you pay back the borrowed money in equal monthly instalments at a fixed interest rate. This type of credit is closed-end, meaning the loan is for a specified amount, and it has to be repaid by a pre-decided date. Most of the time, you cannot increase the amount of the loan later as the instalment credit is at a predetermined amount. A part of your repayment of the loan will be towards the principal amount and a part toward the interest. Instalment credits can be secured or unsecured, and you can also use them to buy items of higher value.

   Examples of Instalment Credit:
   • Auto Loans: Auto loans generally are taken for 24 to 60 months and repaid in equal monthly instalments.
   • Mortgages: When you put your house as collateral and obtain a loan, you are taking the loan on a mortgage loan. Since it has to be paid back in a specified period, it is considered an instalment credit.
   • Personal Loans: Personal loans are used to purchase anything and do not have a fixed end-use. You receive a lump sum at the time of obtaining the loan sum, and you have to pay it back in equal instalments at a fixed interest rate

3. Open-End Credit

   You can borrow and repay from open-end credit accounts again and again. You have to pay back the amount you borrow in full at the end of each billing cycle, and since there is no balance carried to the next cycle, some types of open-end credit accounts do not charge interest. Other open-end credit accounts charge interest only on the amount borrowed. A few open-end credit accounts do not have a set credit limit.

   Examples of Open-End Credit:

   Charge Cards: A charge card is like a credit card. But you need to pay the full amount due at the end of each month to avoid fees or penalties.

   Collection Accounts: An account in collections is sometimes considered an open-end credit.

Credit in Lending and Borrowing

Credit is an important part of our economy as it provides a boost and fills the financial gap for people, allowing them to carry on businesses and other transactions. Credit in lending and borrowing is a financial transaction in which one party, the lender, gives a sum of money or an asset to another party, the borrower, with the understanding that the borrowed amount will be repaid later in the future. The lender fixes the interest rate for the credit, and the borrower has to pay back the principal amount plus the interest.

Advantages and Disadvantages of Credit

Like most things, there are both advantages and disadvantages of credit. We will discuss them in detail:

Things You Should Keep in Mind About Credit

When you are working with credit, you should know a few things about credit:

• It is important to pay your dues on time. If you miss payments, it will impact your credit score and may also lead to higher interest rates in the future.
• You should keep a regular check on your credit reports to ensure they are accurate and do not have any suspicious activity.
• Do not apply for a lot of credit cards. If there is a lot of inquiry into your credit, it can affect your credit score.
• Try to avoid maximizing your credit cards. If you keep the usage within the allowed limit, it will reflect well on your credit score.
• When you get a credit card, ensure you can afford it and are in a position to repay the dues each month.
• If you suspect any fraud or suspicious activity, report it immediately to the lender company.
• It is wise not to close your old account. Keeping your old accounts active will improve your credit score.

Frequently Asked Questions

1. How do I establish credit?

   You can establish credit by applying for and getting approval for a loan or credit card. When you use your credit responsibly to purchase what you need and repay your dues on time, you will build a good credit score.

2. What Is a Credit Limit?

   A credit limit is the maximum amount a lender will allow the borrower to borrow. It can be for a loan or on credit card spending. In short, the credit limit is the total amount of credit available to any borrower.

3. What is a letter of credit?

   A letter of credit is a type of credit. It is a document issued by any lender guaranteeing payment to a seller of goods or services, provided that the seller fulfils certain conditions mentioned in the letter of credit.

4. What Is a Line of Credit?

   A line of credit is a type of loan that provides individuals with a fixed amount of money to use as required. This type of borrowing arrangement is flexible, allowing borrowers to draw funds up to a specified limit as long as they meet all the terms and conditions of the agreement.