Credit is a transaction 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. As a financial transaction, credit is the purchase of the present use of money with the promise to pay in the future according to a pre-arranged schedule and at a specified cost defined by the interest rate. In modern economies, the use of credit is pervasive and the volume enormous. Electronic transfer technology moves vast amounts of capital instantaneously around the globe irrespective of geopolitical demarcations.
In a production economy, credit bridges the time gap between the commencement of production and the final sale of goods in the marketplace. In order to pay labor and secure materials from vendors, the producer secures a constant source of credit to fund production expenses, i.e., working capital. The promise or expectation of continued economic growth motivates the producer to expand production facilities, increase labor, and purchase additional materials. These create a need for long-term financing.
To accumulate adequate reserves from which to lend large sums of money, banks and insurance companies act as intermediaries between those with excess reserves and those in need of financing. These institutions collect excess money (short term assets) through deposits and redirect it through loans into capital (long term) assets.
In a production economy, credit is widely available and extensively used. Because credit includes a promise to pay, the credit purchaser accepts a certain amount of financial and personal risk. Three strategies summarize the reasons for purchasing credit:
A debtor accepts the risks of borrowing to secure something of value, whether perceived or real, profitable or neutral. Borrowing extends one's purchasing power and ability to invest in capital assets to build wealth. But credit is not only used to produce wealth; credit may be necessitated by psychological and cultural factors as well. The following are some of the most common reasons for using credit:
Enjoyment. Credit has come to finance the enhancement of one's life style or quality of life through activities and purchases for enjoyment. Activities "profitable" to one's well being may translate into a more productive economic life. Enjoyment includes the financing of a boat, an education, a vacation, a health club membership, a retreat, etc.
Utilitarian consumption. With the introduction of credit cards in the 1950s and the increase of home equity debt in the 1980s, the financing of daily consumption has greatly expanded. In fact, consumer credit in 1990 was four times that of 1975. Much of this debt was for convenience purchases, consumer goods, and services with a life of less than one year.
Profit and wealth building. The profit incentive plays an important role in the accumulation of capital assets and in wealth building not only for companies—which increase profits through the introduction of capital improvements that must be financed over the long-term—but also for individuals. Home buyers use a similar rationale when buying a house. They expect the purchase of a certain house in a certain location to be more "profitable" than renting or purchasing another house elsewhere. Although a home is not a factory, it is the production backdrop for the capitalist employee selling labor and services.
The credit contract defines the terms of the agreement between lender and borrower. The terms of the contract delineate the borrower's obligation to repay the principal according to a schedule and at a specified cost or interest rate. The lender reserves the right to require collateral to secure a loan and to enforce payment through the courts.
The lender may levy a small charge for originating or participating in a loan placement. This charge, measured in percentage points, covers administrative costs. This immediate cash infusion decreases the costs of the loan to the lender, thereby reducing the risk. The lender may also require the borrower to provide protection against nonpayment or default by securing insurance, by establishing a repayment fund, or by assigning collateral assets.
A promissory note is an unconditional written promise to pay money at a specified time or on demand. The maker of the note is primarily liable for settlement. No collateral is required. A lien agreement, however, holds property as security for payment of debt. A specific lien identifies a specific property, as in a mortgage. A general lien has no specific assignment.
The terms of the credit contract deal with the repayment schedule, interest rate, necessity of collateral, and debt retirement.
REPAYMENT SCHEDULES Credit contracts vary in maturity. Short-term debt is from overnight to less than one year. Long-term debt is more than one year, up to 30 or 40 years. Payments may be required at the end of the contract or at set intervals, usually on a monthly basis. The payment is generally comprised of two parts: a portion of the outstanding principal and the interest costs. With the passage of time, the principal amount of the loan is amortized, or repaid little by little, until completely retired. As the principal balance diminishes, the interest on the remaining balance also declines. Interest on loans do not pay down the principal. The borrower pays interest on the principal loan amount and is expected to retire the principal at the end of the contract through a balloon payment or through refinancing.
Revolving credit has no fixed date for retirement. The lender provides a maximum line of credit and expects monthly payment according to an amortization schedule. The borrower decides the degree to which to use the line of credit. The borrower may increase debt anytime the outstanding amount is below the maximum credit line. The borrower may retire the debt at will, or may continue a cycle of paying down and increasing the debt.
INTEREST RATES Interest is the cost of purchasing the use of money, i.e., borrowing. The interest rate charged by lending institutions must be sufficient to cover operating costs, administrative costs, and an acceptable rate of return. Interest rates may be fixed for the term of the loan, or adjusted to reflect changing market conditions. A credit contract may adjust rates daily, annually, or at intervals of three, five, and ten years.
COLLATERAL Assets pledged as security against loan loss are known as collateral. Credit backed by collateral is secured. The asset purchased by the loan often serves as the only collateral. In other cases the borrower puts other assets, including cash, aside as collateral. Real estate or land collateralizes mortgages.
Unsecured debt relies on the earning power of the borrower. A debenture is a written acknowledgment of a debt similar to a promissory note in that it is unsecured, relying only on the full faith and credit of the issuer. Corporations often issue debentures as bonds. With no collateral, these debentures are subordinate to mortgages.
A bond is a contract held in trust obligating a borrower to repay a sum of money. A debenture bond is unsecured, while a mortgage bond holds specific property in lien. A bond may contain safety measures to provide for repayment. An indenture is a legal document specifying the terms of a bond issue, including the principal, maturity date, interest rates, any qualifications and duties of the trustees, and the rights and obligations of the issuers and holders. Corporations and government entities issue bonds in a form attractive to both public and private investors.
DEBT RETIREMENT Overnight funds are lent among banks to temporarily lift their reserves to mandated levels.
A special commitment is a single purpose loan with a maturity of less than one year. Its purpose is to cover cash shortages resulting from a one-time increase in current assets, such as a special inventory purchase, an unexpected increase in accounts receivable, or a need for interim financing.
Trade credit is extended by a vendor who allows the purchaser up to three months to settle a bill. In the past it was common practice for vendors to discount trade bills by one or two percentage points as an incentive for quick payment. A seasonal line of credit of less than one year is used to finance inventory purchases or production. The successful sale of inventory repays the line of credit. A permanent working capital loan provides a business with financing from one to five years during times when cash flow from earnings does not coincide with the timing or volume of expenditures. Creditors expect future earnings to be sufficient to retire the loan.
Commercial papers are short-term, unsecured notes issued by corporations in a form that can be traded in the public money market. Commercial paper finances inventory and production needs. A letter of credit ("l/c") is a financing instrument that acts more like credit money than a loan. An l/c is used to facilitate a transaction, especially in trade, by guaranteeing payment at a future date. Unlike a loan, which invokes two primary parties, an l/c involves three: the bank, the customer, and the beneficiary. The bank issues, based on its own credibility, an l/c on behalf of its customer, promising to pay the beneficiary upon satisfactory completion of some predetermined conditions. A bank's acceptance is another short-term trade financing vehicle. A bank issues a time draft promising to pay on or after a future date on behalf of its customer. The bank rests its guarantee on the expectation that its customer will collect payment for goods previously sold.
Term loans finance the purchase of furniture, fixtures, vehicles, and plant and office equipment. Maturity generally runs more than one year and less than five. A large equipment purchase may have longer terms, matched to its useful production life. Mortgage loans are used to purchase real estate and are secured by the asset itself. Mortgages generally run 10 to 40 years. When creditors provide a mortgage to finance the purchase of a property without retiring an existing mortgage, they wrap the new mortgage around the existing debt. The interest payment of the wraparound mortgage pays the debt service of the underlying mortgage.
Treasury bills are short-term debt instruments of the U.S. government issued weekly and on a discounted basis with the full face value due on maturity. T-bill maturities range from 91 to 359 days and are issued in denominations of $10,000. Treasury notes are intermediate-term debt instruments ranging in maturity from one to ten years. Issued at par, full face value, in denominations of $5,000 and $10,000, T-notes pay interest semiannually. Treasury bonds are long-term debt instruments. Issued at par values of $1,000 and up, T-bonds pay interest semiannually, and may have call dates (retirement) prior to maturity.
The granting of credit depends on the confidence the lender has in the borrower's credit worthiness. Generally defined as a debtor's ability to pay, credit worthiness is one of many factors defining a lender's credit policies. Creditors and lenders utilize a number of financial tools to evaluate the credit worthiness of a potential borrower. Much of the evaluation relies on analyzing the borrower's balance sheet, cash flow statements, inventory turnover rates, debt structure, management performance, and market conditions. Creditors favor borrowers who generate net earnings in excess of debt obligations and contingencies that may arise. Following are some of the factors lenders consider when evaluating an individual or business that is seeking credit:
Credit worthiness. A history of trustworthiness, a moral character, and expectations of continued performance demonstrate a debtor's ability to pay. Creditors give more favorable terms to those with high credit ratings via lower point structures and interest costs.
Size of debt burden. Creditors seek borrowers whose earning power exceeds the demands of the payment schedule. The size of the debt is necessarily limited by the available resources. Creditors prefer to maintain a safe ratio of debt to capital.
Loan size. Creditors prefer large loans because the administrative costs decrease proportionately to the size of the loan. However, legal and practical limitations recognize the need to spread the risk either by making a larger number of loans, or by having other lenders participate. Participating lenders must have adequate resources to entertain large loan applications. In addition, the borrower must have the capacity to ingest a large sum of money.
Frequency of borrowing. Customers who are frequent borrowers establish a reputation which directly impacts on their ability to secure debt at advantageous terms.
Length of commitment. Lenders accept additional risk as the time horizon increases. To cover some of the risk, lenders charge higher interest rates for longer term loans.
Social community considerations. Lenders may accept an unusual level of risk because of the social good resulting from the use of the loan. Examples might include banks participating in low income housing projects or business incubator programs.
Lenders use both subjective and objective guidelines to evaluate risk and to establish a) a general rate structure reflective of market conditions, and b) borrower-specific terms based on individual credit analysis. To be profitable, lenders charge interest rates that cover perceived risks as well as the costs of doing business. The risks calculated into the interest rate include the following.
Opportunity cost risk. The lender fixes interest costs at a level sufficient to justify making a loan in the present rather than waiting for more advantageous terms in the future. The lender focuses on a desired rate of return rather than the credit worthiness of the borrower.
Credit risk or repayment risk. The borrower may not be able to make scheduled payments nor repay the debt at all. The greater the credit risk, the higher the interest rate. Creditors charge lower interest rates to those with the highest credit ratings, and those who are the most able to pay. In other words, those least able to pay find themselves paying the highest rates.
Interest rate risk and prepayment risk. These risks arise when the payment or prepayment of outstanding debt does not match the terms and pricing of current debt, thus exposing the lender to a "mismatch" in the costs of doing business and the terms of lending.
Inflation risk. Inflation decreases the purchasing power of money. Lenders anticipate these losses with higher interest rates.
Currency risk . International trade and money markets may devalue the currency, decreasing its purchasing power abroad even during times of low inflationary expectations at home. Since currency devaluation heightens inflationary expectations in a global economy, interest rates rise.
Financial intermediation is the process of channeling funds from financial sectors with excesses to those with deficiencies. The primary suppliers of funds are households, businesses, and governments. They are also the primary borrowers. Financial intermediaries, such as banks, finance companies, and insurance companies, collect excess funds from these sectors and redistribute them in the form of credit. Financial intermediaries accumulate reserves of funds through investment and savings instruments.
Banks provide savings and checking accounts, certificates of deposit, and other time accounts for customers willing to loan the bank their funds for the payment of interest. Insurance companies gather funds through various investments and through the collecting of premiums. Banks, finance, and insurance companies also raise cash by selling equity positions or borrowing money from private or public investors. Pension funds utilize available funds from participant contributions and from investment earnings. Federally sponsored credit intermediaries capitalize themselves in a manner similar to banks.
Financial intermediation provides an efficient and practical method of redistributing purchasing power to qualified borrowers. Banks aggregate many small deposits to finance a single family home mortgage, for example. Finance companies break large pools of cash down to sizes appropriate for the purchase of an automobile. The pooling of funds from many sources and the distribution of credit to a large number of creditors spreads the risks.
Managers of financial intermediaries also reduce risk by qualifying borrowers, thereby funneling funds into creditworthy situations. Furthermore, financial intermediation increases liquidity in the system, acting as a buffer against cash shortages resulting from unexpected increases in deposit withdrawals.
Credit securitization is one of the most recent and important developments in financing and capital formation. Underwriters of financial investments gather together a large number of outstanding credit instruments and other receivables, and repackage them in the form of securities which, to the layperson, are similar to closed-end mutual funds. Underwriters sort the credit instruments into homogeneous groups by maturity, purpose, interest rates, and so forth, and market participation in the cash flow generated by the debt instruments backing these securities. Hence, the term "asset backed securities."
In many instances the underlying debt is mortgages, secured by real estate, and guaranteed by some agency or insurance company. For example, an under-writer may place into securitization only mortgages guaranteed by the Veterans Administration of maturities no less than 20 years, with interest rates of not less than 9 percent, and with a cumulative principal (face) value of $10 million. The underwriter sells shares in this pool of mortgages to the public. Other credit instruments securitized are commercial mortgages, auto loans, credit card receivables, and trade receivables.
Credit securitization supports the viability of financial intermediaries by a) spreading the risk over a broader range of investors who purchase the securities, and b) increasing liquidity through an immediate cash infusion for the securitized debt. This process is also helpful to investors and borrowers alike. The large volume and efficiency of the system puts downward pressure on interest rates. The pooling of loans into large, homogeneous securities facilitates the actuarial and financial analyses of their risks.
Investors may participate in a portion of the cash flow generated by the interest and/or principal payments made by borrowers of the underlying debt. Investor participation may be limited to the cash flow of a set number of years, or to a portion of the principal when the underlying debt is retired. Investors also choose to participate at a point suitable to their risk/reward ratio. Hence, investors have the opportunity to derive different benefits from one package of credit instruments.
Altman, Edward I., John B. Caouette, and Paul Narayanan. "Credit Risk Measurement and Management: The Ironic Challenge in the Next Decade." Financial Analysts Journal. January-February 1998.
Guttman, Robert. How Credit-Money Shapes the Economy: The United States in a Global System. M.E. Sharpe, 1994.
Heath, Gibson. Doing Business with Banks: A Common Sense Guide for Small Business Borrowers. DBA/USA Press, 1991.
Rosenthal, James A., and Juan M. Ocampo. Securitization of Credit: Inside the New Technology of Finance. Wiley, 1988.
Wray, L. Randall. Money and Credit in Capitalist Economies: The Endogenous Money Approach. Edward Elgar, 1990.