Credit - a word used quite often in our financial conversations, in some form or the other. Every time you thought about borrowing some money from a friend or taking a loan from the bank - you were actually thinking about credit.
So what exactly is credit and how does it work? Let’s find out.
What is Credit?
Investopedia defines credit as ‘a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at a later date—generally with interest.’
So, when you (borrower) take a loan from a bank (lender), you agree to repay the loan amount within a stipulated time with interest. This is credit as we understand it in our daily lives.
Credit can also mean credit cards, credit reports, credit histories or credit scores in certain cases. Credit is also used when an individual receives money in cash or in his or her bank account. So a credit transaction like salary in your bank statement means that you have received money from a person or an organization.
How Credit Works?
In the case of a borrower and a lender, the borrower ‘buys credit’ from the lender. The most common way of buying credit happens when you use a credit card. You purchase products on credit when you pay for them with your credit card. The bank (lender) pays the merchant on your behalf at that instant and you repay the bank at a later date as mutually agreed upon.
Following healthy credit habits like paying the bills in full and on time (in case of credit cards) help improve your credit worthiness to other financial institutions.
Benefits of Credit
Buying, managing and repaying credit can be quite beneficial in the long run:
- Credit allows you the financial freedom and flexibility to purchase goods and services as and when you require, without worrying about liquid cash
- Credit helps you plan purchases like buying a laptop or a camera without borrowing from family or friends
- Managing and maintaining credit helps you to improve your credit score
- A good credit score can help you secure loans for bigger purchases like buying a home or a car
Types of Credit
Credit comes in a variety of forms. The most common form is bank credit or financial credit. Bank credit includes home loans, car loans, credit cards etc. The bank acts as a lender and loans the amount to you, while agreeing to a repayment plan within a specified time.
Credit can also be non-financial in nature. Two parties may agree to an exchange of goods and services in exchange for a deferred payment. For example, if you get groceries from a local grocery store and the store owner doesn’t ask for payment until the next month, then he is offering a type of credit to you.
So now that you know what is credit and how it works, you should be able to optimise it in your daily life and make better financial decisions. Building and using credit is a financial skill that will help you in your journey towards financial wellness.
