Credit
A form of payment that uses borrowed capital to process a transaction form of payment that uses borrowed capital to process a transaction. It is supplied by a lender, primarily banks and financial institutions.
What Is Credit?
Credit is a form of payment that uses borrowed capital to process a transaction. It is supplied by a lender, primarily banks and financial institutions.
By paying with credit, the borrower creates a contractual agreement to repay the creditor, possibly with interest, for providing capital at convenience.
Once the exchange is processed, it is treated as debt the borrower must pay to the lender.
A textbook would explain the term as lending depositors' money to borrowers within a bank, as depositors would not need access to their funds all at once. Simultaneously, a savings rate is rewarded to depositors for storing their funds and facilitating bank loans.
However, this is a common misconception. A more accurate illustration would be that banks create credit and, in the process, create deposits that are accessible to the borrower to fulfill a transaction.
From an accounting point of view, when a loan is issued, two separate but equal entries are inputted on its balance sheet, one as an asset and the other as a liability.
A loan is recorded as an asset to the bank as the contract holds a value of future principal and interest payments.
The liability represents the bank's existing deposits and newly credited deposits in the borrowers' bank account for their spending purposes, adding capital to an economy.
Banks profit from these transactions by charging higher interest rates to debtors than they advertise to depositors for saving.
Types of Credit
It can be provided by financial institutions in many forms to accommodate the client's spending habits and can be characterized by the loan size to be made more secure for the bank's safety.
1. Revolving
Has a capped limit that borrowers can spend up until. Once the limit has been reached, above-threshold fees apply to excess spending at a higher interest rate.
Regular minimum payments are expected to clear the balance. There are no fixed-term repayments.
Credit cards are a great example of this type; if used correctly, you could increase your score by making sufficient repayments to improve your history. Making reliable payments can convince the bank to increase your limit.
Spending above your limit is not advised, as higher interest payments accompanied by less-than-adequate repayments could exponentially increase your debt and reduce your score.
Overall, it allows flexible payments to be made with borrowed finance.
2. Installments
Installments are typical of large loan products, such as mortgages and student loans, which extend over a longer duration than revolving credit.
Fixed payment schedules are expected to be large; long-term loans are a greater risk to lenders. Therefore regular interest payments effectively reassure the bank that you are committed to paying off the loan for its lifetime.
A high-risk borrower would receive a higher interest rate, claiming larger scheduled payments ensuring the principal value is returned more efficiently.
More frequent scheduled repayments or a co-signer may be added to the conditions of a mortgage to mitigate risk.
3. Open
It is capped by a monthly limit, expecting to pay the full amount borrowed at the end of each month to continue using the balance for the next month.
The model is similar to utility bills which allow you to use the utility service but expect a subsequent payment to be made in full for their services.
What Is a Credit Score?
Their score determines a consumer's creditworthiness, a number between 300–850 which is subject to change depending on their credit histories, such as repayment history and total debt obligations.
A higher score would give borrowers a better outcome for banks to service a loan with favorable conditions as it provides evidence of committed scheduled payments and limited risk.
Fair Isaac Corporation (FICO) created the most commonly used scoring system that financial institutions have adopted.
These scores can significantly affect a person's financial credibility and the prospects of being accepted to purchase goods and services using credit.
Subprime borrowers are classed as individuals with a score below 640, incentivizing lending institutions to penalize them by charging higher rates to compensate for the elevated risk.
More frequent scheduled repayments or a lower credit limit may be implemented to mitigate risk.
Lower interest rates are awarded to borrowers with a score of 700 and above, which is advantageous as they will have to pay less interest when servicing a loan.
Limits may be capped at a lower amount or presented with a higher interest rate if a person displays an undesirable score.
Credit reporting agencies update and store consumers' credit history. Three of the major US rating agencies are:
- Experian
- Equifax
- Transunion
Information collected and the processing methods by the three institutions may differ; however, while calculating scores, there are five essential details to be considered:
- Payment history - contributes to ~35% of a score, incorporating whether they can pay their obligations on time.
- The total amount owed - contributes to ~30% of a score, incorporating the current total credit available to a person and their credit utilization.
- Length of history - contributes to ~15% of a score; a greater documented history provides more support as there is more data.
- Types of credit - contributes to ~10% of a score, showing a variety from revolving to installments is a good indication of utilization.
- New credit - contributes to ~10% of a score, the number of new accounts opened.
Several ways to improve your score include repaying loans on time and keeping debt low. A low outstanding debt obligation is beneficial, showing financial stability and less than frivolous spending habits that could become unmaintainable.
A useful technique can be to increase your limit by calling your bank or stopping yourself from closing down unused accounts, giving the perception that your credit utilization is lower than your allowance.
Credit repair companies provide services to individuals who urgently need a loan and do not have time to improve their scores. These companies negotiate with loan providers to offer the best deal in return for a monthly fee.
Is Credit creation limited?
You may be thinking, "can the banks produce an infinite amount of loans?" and the short answer is yes. A bank can lend as much as they please but only as well as they can manage the risk of absorbing debt burdens.
A bank must hold more assets than liabilities at one time; otherwise, it becomes insolvent, leading to bankruptcy.
Commercial banks hold a central bank reserve to handle interbank settlements and to process fiat currency withdrawals.
A reserve account with the central bank entitles a bank to an amount of fiat currency the government owes. A bank account is money the bank owes to its depositors.
Banks hold a buffer of liquid assets that may consist of profits from interest payments made by borrowers or treasury bonds that can be easily exchanged for cash.
If bank loan assets cannot be repaid in full, the asset could lose value, requiring the bank to conjure its assets to refinance the lost value.
This would consequently close the gap between the bank's liabilities and assets, increasing the risk of its balance sheet.
The central bank can impose reserve requirements as a precautionary measure to reduce the possibility of banks taking on too much risk.
Banking Model
To reiterate, a loan from a bank creates a new asset and liability on a bank's balance sheet.
When a transaction occurs between two separate banks, equivalent proportions of assets and liabilities move to the receiving bank.
The liability has been removed from the first bank and added to the second bank's balance sheet. This requires the first bank to provide central bank reserves to the second bank to secure the added liability.
In this process, the first bank has effectively exchanged its asset in central bank reserves, compensating the added liability to the second bank for a loan agreement that holds value in the future payments it will receive toward the principal and interest.
To simplify, the first bank has maintained its asset value and reduced its liability, while the second has equally gained an asset and liability. Therefore, the credit is demonstrated by the unchanged asset value of the first bank.
Existing central bank reserves cover new liabilities. The total of all central bank reserves should remain constant if it remains a closed network, only changing in total when the central bank releases or absorbs reserves.
Therefore, if there is a bank with a less than abundant reserve to process transactions, there is likely a corresponding bank or banks with a surplus of reserves.
Banks can borrow from one another to fund daily operations, and in return, the borrowing bank pays interest to the lending bank.
These assets and liabilities increase in unison in the banking system, while central bank reserves are a secure asset to carry a bank's liabilities from A to B.
If loans are not paid back, the liability remains in the system while the asset depreciates. Therefore, banks would liquidate any reachable asset belonging to the borrower to reclaim the principal value of the loan, which can be a lengthy process.
Secured debts, such as a mortgage, would foreclose the underlying property and sell it to regain the loss of the assets; however, unsecured debt, such as money spent from a credit card, could require repossession of any assets as a form of payment.
This can destabilize the bank asset-to-liability ratio if the asset value is not recouped. Still, a single default would fail to leave a scratch as banks have a buffer of assets to prevent their liabilities from overtaking them.
In the event of a mass default, the assets held by a bank can depreciate more significantly, resulting in liquidation/bankruptcy, as they do not have sufficient liquid assets to service their liabilities.
To conclude, the proportion of bank assets and liabilities dictates how many loans a bank can create.
What Is A Default?
A default arises if the borrower fails or misses scheduled repayments to their provider for an extended period without any reconciliation or correction. The first three to six months would be long enough for the provider to post a default notice.
At this point, the borrowers must finance the missed payments within two weeks or contact the provider to discuss the reasons for the missed payments.
The provider must be notified as they could help readjust the scheduled payments to be more suited to the borrower, provided a valid reason, such as losing a job or becoming unwell.
A borrower's profile could have recordings of the missed payments, which could affect their chances of acquiring another loan in the future.
They could contact the credit rating agency to update their profile and will also confirm with the provider to ensure their claim is accurate.
Over some time, uncontested defaults will slowly disappear and become less influential as long as the missed payments have been amended.
If the reason is inconclusive or they fail to contact their provider, they can be legally summoned to a court hearing where the matters are much worse.
They must either convince the jury about their arguments for missing payments or negotiate a repayment method that could result in the repossession of assets to pay off the debt.
Money supply
Compared to US Reserve Notes, most US money in circulation exists as digital money on a bank's balance sheet system.
Fiat money represents physical money that is printed and has a value backed by the central government. The stability of the government and economy where the fiat currency resides determines its value and security.
All current/saving accounts available to consumers are liabilities to the bank, as they are obligated to pay depositors an equivalent amount of fiat currency upon withdrawal request. Otherwise, they remain as digital figures on the bank's balance sheet.
As fiat currency holds no intrinsic value and is not associated with another commodity commemorating the gold standard, fiat currency is subject to inflation or deflation.
Inflation can occur in a monetary system when the supply of money increases, correlating with economic growth. Inversely, deflation can occur when the supply of money shrinks in correlation with economic contraction.
Borrowed capital from a bank is transacted between buyer and seller when purchasing goods and services.
The seller's deposit account increases in value which uplifts their creditworthiness, as he can withdraw a larger loan using the greater capital backing compared to the initial buyer.
More factors contribute to creditworthiness and loan agreements; however, this is a general outlook.
Each transaction extrapolates more money from the bank, adding to an economy's money supply and stimulating growth from consumer spending and investments.
However, an individual's income is another individual's debt.
When a borrower makes a principal payment to the bank, the amount is equally deducted from the bank's liabilities (the borrower's current account) and the bank's assets. Therefore, the credit/debt is entirely removed from the monetary supply, acknowledged as deflationary.
Money creation can promote inflationary or deflationary pressures when issued by banks but can ultimately be moderated by the central bank through monetary policy.
More frequently, money is created as it stimulates spending and economic growth. Therefore, a steady inflation rate of 2% is considered progressive to keep an economy stable and functional for more developed countries.
Periods of rapid growth caused by excessive consumption result in high inflation. This incentivizes the central bank to lower economic activity by making it more expensive to service loans.
High inflation lowers the purchasing power of fiat currency as growth causes expansion and the consumption of more resources, increasing business costs that are transferred to consumers and other less progressive businesses.
Credit and Interest rates
Interest rates determine the cost of debt and return on savings.
For investment products, such as savings, the annual return or interest received is presented as an annual percentage yield (APY). Whereas for loans, interest is displayed as an annual percentage rate (APR).
The Federal Reserve influences APR and APY by adjusting the federal funds rate.
Banks need a sufficient reserve account at the central bank to remain operational. If a bank does not hold a sufficient reserve account, it can borrow funds from another bank at an interest rate influenced by the federal funds rate.
The federal fund rate is a target set by the Federal Open Market Committee (FOMC), but banks do not have to conform to this rate. Instead, negotiations between banks allow different rates to be drafted, eventually determining an agreeable rate.
The federal fund rate target is achieved by changing the interest on reserves (IOR). A bank's reserve account receives interest from the central bank, the lowest possible and risk-free interest.
As banks would like to receive the highest possible yet most competitive rate for lending their funds, they would likely provide capital to a bank at a rate reasonably higher than the IOR.
A rate lower than the IOR could be dismissed as the bank would gain more interest from holding it in its reserve account.
Consequently, a bank's borrowing reserves must preemptively charge a reasonably higher interest rate to consumers than the interbank lending rate to remain profitable.
The IOR is the primary tool used by the Fed to achieve its congressional mandate of maximum employability and price stability.
Inflation is a factor that can negatively impact their mandate by eroding the value of the dollar caused by high consumer demand and monetary expansion. Therefore, interest rates are raised to lower consumer demand as credit is more expensive to finance.
Saving rates increase simultaneously, prompting consumers to keep their deposits at a bank to receive payable interest instead of spending.
The ability to borrow money provides risk to creditors as there is a chance the money may not be paid back fully. Interest allows residual payments to enter a creditor's account, inspiring confidence that the borrower is committed to making repayments.
If the borrower defaults, the creditor won't lose all of his money as interest installments allow some money to be returned. In addition, other assets may be liquidated to recuperate the remaining expenses.
Their score determines a consumer's creditworthiness, a number between 300–850, which is subject to change depending on their credit histories, such as repayment history and total debt obligations.
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