Log In Start studying!

Select your language

Suggested languages for you:
StudySmarter - The all-in-one study app.
4.8 • +11k Ratings
More than 3 Million Downloads
Free
|
|
Credit

When you go to the store, do you pay by cash, debit, or credit? What even is credit anyway? A lot of us might just swipe our credit cards or take out loans without knowing exactly what it entails. Credit isn't free money, it's just borrowed money: and a lot of the time there's interest charged too. To learn more about the different types of credit, the differences between debit and credit, and even to go through some examples of what credit could look like, keep reading on!

Credit Definition in Economics

Credit is primarily a link formed between a lender and a borrower. The borrower agrees to pay the lender back, usually with interest, or face monetary or legal consequences. The main way this is used today is by the use of credit cards. By using credit cards, there's now a middle man involved - the bank. When you purchase an item at the store and pay for it with your credit card, the bank will pay the store for your item and now you owe the bank money, which you will pay back with interest.

Credit is primarily a link formed between a lender and a borrower where the borrower agrees to pay the lender back, usually with interest.

And along with credit, there is something called the terms of credit. This is a deal between a supplier and consumer that specifies the schedule and quantity of prospective payments that the customer will make.

Terms of credit is a deal between a supplier and consumer that specifies the schedule and quantity of prospective payments that the customer will make.

These terms are:

  • The interest rate - In addition to the principle amount, the debtor must pay interest.
  • Collateral - It's an asset owned by the debtor that serves as a security to the creditor until the debt is paid.
  • Documentation - Borrowing documents that include all contract terms must always be presented.
  • Repayment method - The manner in which the debtor will pay off the loan has to be specified. Lengthy loans could be paid back in annual, semi-annual, or monthly payments.

Common Forms of Credit

There are three main types of credit:

  • installment
  • revolving
  • open

Installment credit

Installment is a sort of credit that has a set payment plan for a certain period of time. A mortgage is an excellent illustration of an installment credit. You must pay a specified amount of money at regular intervals until the debt is paid off. Student loans are another great example.

Installment credits are credits that have a set payment plan for a certain period of time.

Revolving credit

Revolving credit is a sort of credit that has a limited amount and can be utilized up until the specified limit is met. It could contain minimum monthly payments, though there is generally no set payback timeline. A credit card, for example, has a limited amount so you can keep using the card for spending until you hit that threshold.

Revolving credit is a sort of credit that has a limited amount and can be utilized up until the specified limit is met.

Open credit

An open credit account is one that needs payment in full for every period, like every month. One can borrow up until a certain amount, but they must repay the loaned cash in its entirety at the close of each term. An electricity bill is an example of this: you can use all of the electricity you want to charge devices, power household appliances, etc., and at the month's end, you must make the payments for the amount of electricity you used.

Open credit is credit that needs payment in full for every period, like every month.

Sources of Credit in Economics

There are multiple sources of credit in economics. Some of these are:

Commercial banks

Commercial banks are the first source of credit people usually think of. They give credit to people in the state of personal loans, school loans, mortgages, etc. Banks are a useful credit source since many individuals have accounts there. However, bank credit might be costly in certain situations due to extremely high-interest rates. Banks might also charge a variety of costs such as banking fees, processing fees, paperwork fees, and so on.

Financial institutions

Financial institutions are specialized credit firms that only disburse credit. They don't provide the additional services that commercial banks do, such as taking deposits. They are especially crucial when major corporations require significant loans over a long period. Essentially, they're an excellent source of lending, particularly when the demand is large and long-term. However, their credit-granting requirements are often fairly strict. They may also supervise the borrowing firm's actions, which might be restricting at times.

Credit cards

Credit cards are a popular form of credit.

Credit, Credit card, StudySmarterCredit card, pixabay

The bank that issues the card or the firm that issues the card pays the vendor in the customer's place. The owner of the credit card must then refund this money within a certain time frame. A plus of credit cards is that they provide an immediate source of credit when used to acquire any commodity or service. The disadvantage is that it is among the most expensive types of loan if the borrower fails to meet the payment date. Interest rates are excessive, frequently ranging from 25% to 30% per year, and the lender might demand large sums of money rather than late payment penalties if the borrower misses a payment.

Public deposits

Population deposits are a direct source of credit from the public at large. They can lend a firm funds for a set length of time in exchange for interest. Because these assets must contend with bank and federal assets, the interest rate must be significantly higher. Lending via public deposits is typically less expensive than lending via banks. The issuance process is straightforward and depositors have no power over the firm. However, only businesses with a proven history and credibility in the market may benefit from such deposits.

Trade credit

Trade credit is a type of credit that is associated with a company's everyday activities. With trade credit, a company purchases products or services via a vendor on credit and promises to pay the vendor within several days. It is a type of short-term loan that is granted based on the purchaser's reputation and market credibility. The major benefit of this type of financing is that it is usually interest-free. As a result, the buyer accrues no extra costs in order to get trade credit. It is also easily accessible, with no hassles or long paperwork. It is free of cost on the company's assets and is useful in the event of unexpected large supply requests. The issue is that it is contingent on the desire of the seller of products. The seller may refuse to provide products and services on credit at the very last minute, which might be a huge blow for the customer.

Differences Between Debit and Credit

The main differences between debit and credit are:

  • When you add assets to a record, the difference is a debit since something has to be paid for that addition.

  • A spike in debt, on the other hand, is a credit since it represents money borrowed from someone else and utilized to buy goods or services.

Credit in Economics Examples

Let's go through some examples of credit:

Imagine you go to the store and you want to buy a new phone. You don't have any cash on you, and you know that you don't get paid until next week so your bank account doesn't have quite enough money to cover the cost of the phone you want. You decide to use your credit card to purchase the phone and pay off your credit card bill in full when you get your paycheck next week. In this way, you are using a form of credit, because you are borrowing the money with the knowledge that you have to pay back the money you were loaned at a later date.

Let's say you've been saving up for a while to afford a down payment on a new car. You go to the dealership and find a car you really like for $20,000. After speaking to the dealer, you find out that you have just enough to cover the down payment on the car, which is $4,000. You're left with $16,000 that you would still owe if you were to buy the car. The dealer informs you that you can choose to pay the car off in installments, so you would be able to pay monthly payments over the course of 60 months. This would cost you roughly $267 a month. After signing all of the paperwork, you've now entered into an installment credit loan where you must pay regularly until the entirety of the car is paid off in full.

Credit - Key takeaways

  • Credit is primarily a link formed between a lender and a borrower where the borrower agrees to pay the lender back, usually with interest.
  • Installment loans are credits that have a set payment plan for a certain period of time.
  • Open credit is credit that needs payment in full for every period, like every month.
  • Revolving credit is a sort of credit that has a limited amount and can be utilized up until the specified limit is met.
  • An electric bill is an example of open credit.

Frequently Asked Questions about Credit

Credit is primarily a link formed between a lender and a borrower where the borrower agrees to pay the lender back (usually with interest).

Terms of credit is a deal between a supplier and consumer that specifies the schedule and quantity of prospective payments that the customer will make.

When you add assets to a record, the difference is a debit since something has to be paid for that addition. 

A spike in debt, on the other hand, is a credit since it represents money borrowed from someone else and utilized to buy goods or services.

A line of credit is the amount of money open to the borrower to borrow.

Installment, revolving, and open

Final Credit Quiz

Question

What is credit?

Show answer

Answer

Credit is primarily a link formed between a lender and a borrower where the borrower agrees to pay the lender back (usually with interest).

Show question

Question

Define terms of credit

Show answer

Answer

Terms of credit is a deal between a supplier and consumer that specifies the schedule and quantity of prospective payments that the customer will make.

Show question

Question

What are the four parts to the terms of credit?

Show answer

Answer

The interest rate, collateral, documentation, repayment method

Show question

Question

What are the three types of credit?

Show answer

Answer

Installment, revolving, and open

Show question

Question

What's installment credit?

Show answer

Answer

Installment credits are credits that have a set payment plan for a certain period of time.

Show question

Question

What's revolving credit?

Show answer

Answer

Revolving credit is a sort of credit that has a limited amount and can be utilized up until the specified limit is met.


Show question

Question

Define open credit

Show answer

Answer

Open credit is credit that needs payment in full for every period, like every month. 

Show question

Question

Name at least two sources of credit.

Show answer

Answer

Commercial banks, financial institutions, credit cards, public deposits, trade credit

Show question

Question

When you add assets to a record, the difference is a debit since something has to be paid for that addition. 

Show answer

Answer

True

Show question

Question

An increase in debt is a ______ since it represents money borrowed from someone else and utilized to buy goods or services.

Show answer

Answer

credit

Show question

Question

Credit isn't free money; it's just ________ money


Show answer

Answer

borrowed

Show question

Question

 A mortgage is an excellent illustration of a(n) _________ credit


Show answer

Answer

installment

Show question

Question

What's the disadvantage of credit cards?

Show answer

Answer

The disadvantage is that it is among the most expensive types of loan if the borrower fails to meet the payment date.

Show question

Question

What's meant by the repayment method?

Show answer

Answer

It means that the manner in which the debtor will pay off the loan has to be specified. 

Show question

Question

________ ______  are the first source of credit people usually think of.

Show answer

Answer

Commercial banks

Show question

60%

of the users don't pass the Credit quiz! Will you pass the quiz?

Start Quiz

Discover the right content for your subjects

No need to cheat if you have everything you need to succeed! Packed into one app!

Study Plan

Be perfectly prepared on time with an individual plan.

Quizzes

Test your knowledge with gamified quizzes.

Flashcards

Create and find flashcards in record time.

Notes

Create beautiful notes faster than ever before.

Study Sets

Have all your study materials in one place.

Documents

Upload unlimited documents and save them online.

Study Analytics

Identify your study strength and weaknesses.

Weekly Goals

Set individual study goals and earn points reaching them.

Smart Reminders

Stop procrastinating with our study reminders.

Rewards

Earn points, unlock badges and level up while studying.

Magic Marker

Create flashcards in notes completely automatically.

Smart Formatting

Create the most beautiful study materials using our templates.

Sign up to highlight and take notes. It’s 100% free.

Get FREE ACCESS to all of our study material, tailor-made!

Over 10 million students from across the world are already learning smarter.

Get Started for Free
Illustration