What is Credit?
Credit is an agreement whereby a financial institution agrees to lend a borrower a maximum amount ofover a given time period. Interest is typically charged on the outstanding balance.
How Does Credit Work?
Credit cards and homelines are examples of credit. Your bar tab is another form of credit.
Not all lines of credit are alike. The borrower's creditworthiness and relationship with the lender affect the terms of the lending agreement, as does bank competition, prevailing conditions and the size of the line in question. Some apply fixed amortization rates to outstanding balances on a line of credit, while some permit interest-only payments for a time, followed by a lump-sum payment of the principal. If the lender has the right to demand at any time, this is called demand credit.
As with any debt, a wide array of specific terms and requirements may apply to a line of credit. It is common in a revolving line of credit, for example, for the lender to charge a company a commitment fee to keep the unborrowed portion of the line available to the borrower. also may require a compensating balance, liens on the borrower's assets or collateral on a percentage of the line. This is called securing the line. Some lines of credit are unsecured and are thus not backed by specific assets (this often the case with credit cards). Interest rates on unsecured lines are generally higher than secured lines to compensate the lender for the added risk in the event of a default.
Why Does Credit Matter?
Credit gives borrowers the ability to purchase goods and services (or for companies, credit gives borrowers the ability to invest in projects) that they normally might not be able to afford. By lending the money, creditors make money by charging interest while helping borrowers pursue their projects. However, as many people have learned the hard way, taking on too much debt can lead to financial trouble.