Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
What Is Credit?
Jan just purchased her first home and moved in today. Her next door neighbor came over to introduce herself and welcome her to the neighborhood. Jan greets her and gives her a tour of the home. Her neighbor asks, 'Where's your furniture?' Jan embarrassingly responds that she used all of her cash to buy the home and will have to buy a little at a time. The neighbor tells her she could use credit to purchase the major furniture items.
Credit allows consumers to take possession of the items with a promise to repay over a specific period of time. Jan visits the furniture store her neighbor suggested and inquires about its credit options. For the rest of this lesson, we'll discuss the three different types of consumer credit: installment, non-installment, and revolving credit. You'll also learn about repayment requirements and if there's a cost to borrow the money.
A furniture sales person named Tom greets Jan and asks her to complete a credit application. While she was filling out the application, Tom tells Jan the lenders will review her creditworthiness, or her ability to repay.
They usually review what's called the five Cs of good credit: character, capacity, capital, collateral, and conditions. Character means how long you've been employed and if you pay your bills on time. Capacity evaluates your income and household expenses. Capital equals how much you own minus how much you owe. Collateral represents something tangible the borrower provides the lender in the event of default. Examples of collateral include a deposit, car, and home. Lastly, lenders take into considerations conditions, which include such things as the economy. Now let's review the different types of credit.
Tom starts by discussing installment credit, which is the best type of credit when a customer wants to furnish the whole house rather than piece by piece or room by room. Installment credit is where the lender provides approval for that particular purchase and credit does not extend beyond that amount. It is not possible to add additional purchases to this type of credit, and once the original amount is paid off, Jan or any other customer must reapply if further credit is needed. The repayment period could extend months or years, depending on the original arrangement.
Additionally, the money is not free. Jan will be required to pay interest on the purchase price. Interest is the cost to borrow money, and it is how lenders make money. Tom explains the interest rate is dependent on how much is borrowed, the repayment period, and the borrower's credit rating. Jan explains to Tom that she just purchased a home, so her credit rating is excellent. Tom says, 'Great, then your interest rate should be pretty low.' Other examples of installment credit are car, mortgage, and student loans. All of these loans represent a single fixed amount of money given at a specified interest rate. Installment credit is not the only option Tom has for Jan, though, so he next talks about non-installment credit.
Tom asks Jan if she's ever seen commercials on TV advertising 30, 60, or 90 days, same as cash? Jan says yes, but since she does not have much cash after purchasing the home, she's never inquired more about this type of credit. Tom says that it was probably a good idea because non-installment credit requires you to repay in a lump sum payment, usually in a short period of time.
This type of credit may or may not include interest. Sometimes a lender will offer non-installment credit with no interest and if the borrower is unable to pay it off, the lender will switch it to an installment loan with interest. Tom tells Jan she's right; she'll need to build up more cash to use this type of credit and pay it off in full at the end of the borrowing period. However, she may be interested in revolving credit, which he discusses next.
Revolving credit is similar to a credit card - when charges are paid, the amount is available to make purchases. Customers are free to charge any amount up to the credit limit. If the customer has not reached the limit, then they can add additional purchases up to the credit limit. Each month the borrower will make payments towards the balance, plus interest, until the balance is paid off. It's important to make payments on time, and if the customer does, the lender may periodically increase the credit limit. However, if payments are late, the lender can reduce the credit limit and leave negative marks on the borrower's credit report.
Tom asks Jan which credit option she thinks would work best for her. Jan responds by saying, 'Revolving credit would be best for my situation; I can purchase as much as my budget will allow, pay it off, then purchase more furniture.' Tom agrees to use this option, and they work to get furniture for her house.
Let's review. There are many credit options available when you're short on cash or simply want to use credit. As we learned, credit allows you to take possession of your items and pay for them later. However, before a lender will give you credit, they will assess the five Cs of good credit. These include character, capacity, capital, collateral, and conditions. There are three main types of credit: installment, non-installment, and revolving credit. Installment credit is where a lender approves you for a certain amount but credit does not extend beyond that amount. Non-installment credit requires repayment in a short amount of time. Revolving credit is similar to a credit card - when charges are paid, the amount is available to make purchases. It's important to note, installment and revolving credit will require the borrower to pay interest, which is the cost to borrow money. On the other hand, non-installment credit may or may not impose interest.
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