Credit is a contract between two parties in which one,
acting as creditor or lender, supplies the other, the debtor or borrower, with
money, goods, services, or securities in return for the promise of future
payment.
According to a pre-arranged schedule and at a particular
cost mentioned by the interest rate, credit as a financial transaction is the
purchase of the present use of money with the promise to pay at some point.
The use of credit is unrelenting and there is huge volume in
modern economies. In spite of geopolitical demarcations, electronic transfer
technology moves vast amounts of capital instantaneously around the globe.
Reasons for Purchasing Credit
Credit is widely available and extensively used in a
production economy. The credit purchaser accepts a definite amount of financial
and personal risk, since credit involves promise to pay.
There are three strategies
to review the reasons for purchasing the credit:
- At
helpful times, the absence of liquidity averts profitable investments.
- In the
present, favorable borrowing costs make it less expensive to borrow than
in the future. Borrowers may have prospect of rising rates, tight credit
supplies, growing inflation, and decreasing economic activity.
On the
other hand, in order to justify present investments that involve financing,
profit expectations may be sufficiently favorable.
- The
cost of borrowing will be decreased with tax incentives, which expense or
deduct some interest costs, and lend a hand in capital formation.
Credit Terms
Repayment schedules - By means of maturity, contracts
will differ. Long-term debt is more than one year, up to 30 or 40 years.
Short-term debt is from overnight to below one year.
Towards the end of
contract or at set intervals, payments may be required, typically on a monthly
basis.
Interest rates - Interest is the cost of purchasing
the use of money, i.e., borrowing. In order to cover administrative costs,
operating costs, and a suitable rate of return, the interest rate charged by
lending institutions must be sufficient.
For the term of the loan, interest
rates may be fixed, or adjusted to replicate varying market conditions.
Collateral - Collateral is nothing but assets vowed
as security against loan loss. Credit backed by collateral is secured. The
asset acquired by the loan often serves as the only collateral.
In other cases,
the borrower puts other assets, together with cash, to one side as collateral. Mortgages
are collateralized by real estate or land.
Debt retirement - Overnight funds are lent among
banks to lift their reserves to authorized levels temporarily.
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