Defining Credit

The exchange of goods and services for monetary benefits is a traditional practice. From the beginning of civilized society, people have been bartering goods for currencies of various ages. But what happens when one party is unable to pay the required amount in the present?

Here comes the role of credit. Credit, in simple folk language, is the process of carrying out the transaction between two parties, as intended, with the payment being promised to deliver later in the future.

In such transactions, there is usually a third-party involvement. This party is the one actually paying the amount currently on behalf of the debtor, i.e. person who has purchased the goods. Later on, the debtor will pay the amount back to this party, usually with an interest amounting to the original price.

The bank is a genuine example of a third party currently. It usually gives the users credit for purchasing products and paying later. People confuse credit with loans.

Credit Vs. Loan

Credit and Loans are two different types of financial aid the bank provides. Banks give them to make the user experience smooth and allow them to carry out their work without any interruptions or lack of funds.

Some essential points of difference between loan and credit are :

LOAN -

1. A loan is a particular sum of money a bank issues to be made available to the user.
2. It is used whole, with interest fixed on the total amount.
3. The duration of any loan is usually more than 3 years.
4. The loan renews only when the existing one is fully paid off, including the interest.

CREDIT -

1. Credit is the sum of money the bank issues upto a specific limit which varies with the user.
2. The user uses the amount either wholly or partially.
3. The interest applies to the amount that remains pending.
4. The duration of credit is 1 year at max.
5. The credit usually renews after payment of the credited amount until the maximum limit is reached.

Working of Credit System

When a person desperately needs any product or service, he seeks credit from various sources. The prominent sources of credit lending are - Banks, Credit Unions, Finance Companies, Saving and Loan Institutions, etc.

These grant the debtor the credit money to buy that item. On the debtor's behalf, they make the full payment for that item to the merchant. Then, they collect the principal amount along with a predetermined interest rate from the debtor over a period of time.

Usually, the payment takes place monthly. They fix a certain amount, including interest, that the creditor pays monthly. This is the EMI (Equated Monthly Instalment) system of credit recollection.

Types of Credit

There are primarily 4 types of credits that a person can avail from any of the sources mentioned above.

Revolving credit -

This credit is frequently in use. There is a certain amount upto which the debtor can avail the credit from a bank or other financial institution. This amount is then repaid over the course of one month as per the user’s choice. This credit limit keeps revolving from one month to another and can be carried over.

Service credit -

In this type of credit, a service is availing happens on a contractual basis with credit agreements. The payment of all the charges incurred during this tenure of one month pays off at the end of the month. Thus, the user can easily enjoy the benefits without regular payment issues.

Installment credit -

These are the types of credit that resemble a loan very closely. Here, money is repaid in a fixed pattern, and the debtor has to pay a predetermined amount within a specific time limit. Collateral is necessary to issue such credit, and huge interest imposes on delayed payments.

Charge Cards-

The charge cards are essentially similar to the revolving credit system. The only point of distinction being the monthly payment factor. While the user is able to carry his credit to the next one in the latter, this is not possible on the charge card. The dues will settle at the month's end itself.

Credit Score

We have understood the fundamentals of credit. We know the 4 major types of credit systems and the process of the credit system. But can we identify a genuine person applying for credit?

It will be a huge catastrophe if the person turns out to be a defaulter. This mistake can lead to a big economic crisis, as seen in fraud and money laundering cases. Therefore it is necessary to determine the credit worthiness of an individual before issuing any credit to that person.

Currently, there are 3 significant bodies that govern the credit scoring of an individual person. These are - Experian, TransUnion, and Equifax.

The FICO score is the most popularly used method of credit score calculation. A score of 900 is the best. If you have a score below 300, you are not credit worthy. If the score of a person is lower, then he is not considered worthy of credit.

A higher score not only allows you to get credit but also avail some additional benefits. Thus, the FICO score is the method to understand the credit score of an individual.

Building a good Credit score

Some techniques help you build a good credit score above 500.

1. Ensure timely payment of the installments. It is essential to pay your installments before time to keep your credit score healthy.
2. Do not close your credit accounts. Keep your credits open always. The age of your account is paramount to your credit score calculation.
3. We advise you to utilize only 30% of your credit. The less you take credit, the better your score remains.
4. Never apply for multiple credit cards spontaneously. We recommend that you keep a minimum gap of 6 months between applications.

FAQs

1. What are the 3 major problems with using credit?

The 3 major issues of credit usage are -

1. Lack of enough credit history
2. Theft and fraudulent cases
3. Denial of credit application
4. How to maintain a good credit score?

To maintain a good credit score, keep your credit usage minimum and pay installments on time.

1. What are the 4 benefits of a credit score?

Credit is useful in the following cases-

1. Ease in getting utility and service
2. Easy approval on loans and credits.
3. Availment of higher credit limits with time.
4. Get better rates of interest than others.
5. What does credit indicate about you as a person?

A credit is helpful to understand your risk-taking capabilities. It also measures your maturity and patience level.