The term “credit” carries multiple meanings in the financial realm, but it most commonly refers to a contractual agreement wherein a borrower receives a sum of money or another valuable asset and commits to repaying the lender at a later date. This typically involves the addition of interest.
Credit may also denote the creditworthiness or credit history of an individual or business—phrases like “she has good credit” exemplify this. In accounting, ‘credit’ pertains to a specific type of bookkeeping entry.
Key Takeaways
- Credit is primarily defined as an agreement between a lender and a borrower.
- It can also reflect an individual’s or a business’s creditworthiness.
- In accounting, a credit is a bookkeeping entry that decreases assets or increases liabilities, in contrast to a debit.
Credit in Lending and Borrowing
Credit is an agreement between a lender (creditor) and a borrower (debtor). The borrower pledges to repay the lender often with interest, or face financial or legal repercussions. Extending credit is an ancient practice dating back thousands of years to the dawn of civilization.
Various forms of credit exist. Common examples encompass car loans, mortgages, personal loans, and lines of credit. When a financial institution grants a loan, it generally credits that amount to the borrower, who must repay it over time.
Credit cards are pervasive today, enabling consumers to purchase nearly anything on credit. The issuing bank acts as an intermediary, covering the seller’s payment, while extending credit to the buyer who repays the debt over time with accrued interest.
Receiving services or products without immediate payment is another form of credit. For example, a restaurant receiving produce from a wholesaler on the understanding that payment will be due after a month demonstrates this concept.
Other Definitions of Credit
Credit is often shorthand for an entity’s financial soundness. Good or excellent credit signifies lower risk to lenders compared to poor credit.
Credit scores classify individuals based on risk, as utilized not only by lenders but also by insurance companies, landlords, and employers. The FICO score, ranging from 300 to 850, is a standard measure:
- 800+ denotes exceptional credit
- 740-799 stands for very good credit
- 670-739 is good credit
- 580-669 is fair credit
- 579 or below signifies poor credit
Companies likewise face evaluations from credit rating agencies, such as Moody’s and Standard & Poor’s. These ratings, often letter grades, significantly affect bond investors and the interest rates companies must offer to borrow money. Government securities ratings, like those for U.S. Treasuries, are based on the issuer’s perceived credit solidity.
In accounting, ‘credit’ has a very particular meaning. It’s a bookkeeping entry that decreases assets or increases liabilities. For instance, suppose a retailer buys merchandise on credit; this increases its inventory account (via a debit), adding an asset, while simultaneously increasing accounts payable (via a credit), a liability.
Understanding a Letter of Credit
Commonly employed in international trade, a letter of credit is a bank-issued letter ensuring that a seller will receive the full amount due from a buyer by a pre-agreed date. Should the buyer default, the bank covers the cost.
Defining a Credit Limit
A credit limit is the highest amount of credit a lender will provide to a borrower. Reaching the limit halts further purchases until some portion of the balance is repaid. This term also applies to lines of credit and buy-now-pay-later loans.
Exploring a Line of Credit
A line of credit refers to a loan wherein a bank or financial institution allows a borrower to draw on a specified amount of credit as needed, instead of taking the entire sum at once. The home equity line of credit (HELOC), allowing homeowners to borrow against their property’s value, is one example.
What Is Revolving Credit?
Revolving credit permits borrowing without a fixed end date—credit card accounts exemplify this concept. Borrowers can continue to draw funds up to the credit limit as long as the account remains in good standing. Payments chip away the balance and replenish the account, characterizing such loans as open-end credit. By contrast, mortgages and car loans are closed-end credit with a definitive end date.
Conclusion
“Credit” encompasses several meanings in personal and commercial finance, predominantly signifying the capability to purchase now and pay later. Arrangement can be direct between buyer and seller or facilitated by an intermediary like a bank. Credit plays an essential role in enabling commerce to operate seamlessly.
Related Terms: bank loans, credit rating, debit, credit card, letter of credit, credit limit.
References
- Experian. “What Is a Good Credit Score?”
