Principles of Business & Consumer Credit

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

More and more, world economies are relying more on credit and less on cash as a medium of exchange. In this lesson, we'll define credit, discuss the differences between business and consumer credit, and talk about the economic impact of credit.

Principles of Business & Consumer Credit

Credit, as it relates to economics, is best defined as the ability for a buyer to take possession of goods or services prior to payment based on the trust of the seller in the buyer that payment will occur, based on agreed terms, in the future. It's a mouthful, but seeing as credit is a fundamental, significant part of the world economy, it is important to understand.

Credit is a financial tool that can be used by businesses and consumers and is an important part of economic growth, if used strategically and responsibility. While the general definition of credit applies to both businesses and consumers, there are important distinctions. Before we talk about how they differ, let's discuss the things that business and consumer credit have in common.

Similarities

Here are two important aspects of credit that have universal application: it can be good, and it can be abused. The financial crash that led to the 'great recession' of 2008 was almost exclusively caused by businesses and consumers abusing credit and lenders allowing - and in some cases, helping - people to misuse credit. But, on the flip side, the economic growth we've seen since 2009 has been possible because of credit.

Another important similarity is that credit isn't free, nor can everyone have it. Lenders typically charge interest on credit. Interest is the cost of credit. While the specific interest rate for a loan to a business or consumer is determined by many factors, two of the most important are based on the riskiness of the borrower and the time value of money (money loses value over time).

Not all companies and individuals get credit. Lenders base their credit decisions on a few factors, often summarized as the 5 Cs of credit. The 5 Cs of credit are capacity, character, capital, conditions, and collateral. Let's take a very basic look at the definitions of each of these.

  • Capacity is the ability of the borrower to make required future payments. A business with $100 million in cash flow has more capacity than a business with $1 million in cash flow.
  • Character is reflected in credit reports and credit scores, which take into account things like how credit is used, if payments are made on time, and how much available credit is used.
  • Capital is the amount of the total cost of the product or service the borrower is investing. A house is a good example. Lenders will be more comfortable loaning $200,000 to an individual for a house if it's a $250,000 house, and the borrower is paying $50,000 of their own money, than if it's a $200,000 house and the borrower isn't investing of their own money.
  • Conditions refer to individual and economic conditions. In 2007-2008, it was almost impossible for businesses or individuals to get credit, based mostly on the economic conditions. But similarly, if a business is suffering from company-specific or industry-specific challenges, their ability to obtain credit may be limited.
  • Collateral is the physical product that the credit is financing. If you get an auto loan, the car is collateral. If you get a house, the house is collateral. Lenders are usually more comfortable lending if collateral exists, since the possibility of losing that collateral typically motivates borrowers to repay the loan.

Differences

While the basic idea of credit can be related to businesses and consumers, there are differences - mostly related to how credit is used. For example, while it is a good rule of thumb for both consumers and businesses to use credit for investments, not operating costs, the reality is that consumers use credit for 'operating costs,' while doing so in business is seen as a very big red flag.

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