Credit

Obtaining Credit

Credit is a term used to denote transactions involving the transfer of money or other property on promise of repayment.

Learning Objectives

Describe the concept of credit and how consumers can obtain in for transaction purposes

Key Takeaways

Key Points

  • Credit encompasses any form of deferred payment. Credit does not necessarily require money. The credit concept can be applied in barter economies as well, based on the direct exchange of goods and services.
  • Obtaining credit is dependent on the reputation or creditworthiness of the entity which takes responsibility for the funds.
  • In the U.S., when a customer fills out an application for credit from a bank, store or credit card company, their information is forwarded to a credit bureau.
  • Lenders like to see consumer debt obligations paid regularly and on time, and therefore focus particularly on missed payments and may not, for example, consider an overpayment as an offset for a missed payment. The other factor in determining whether a lender will provide a consumer credit or a loan is dependent on income. The higher the income, all other things being equal, the more credit the consumer can access.

Key Terms

  • creditor: A person to whom a debt is owed.
  • debtor: A person or firm that owes money; one in debt; one who owes a debt
  • credit report: A document of the history and current status of a borrower’s credit standing, and may include identifying information, credit information, public-records information, recent inquiries and credit score.

Credit, in commerce and finance, is a term used to denote transactions involving the transfer of money or other property on promise of repayment, usually at a fixed future date. The transferor thereby becomes a creditor, and the transfer, a debtor; hence credit and debt are simply terms describing the same operation viewed from opposite standpoints.Credit encompasses any form of deferred payment. Credit does not necessarily require money. The credit concept can be applied in barter economies as well, based on the direct exchange of goods and services (Ingham 2004 p. 12-19). However, in modern societies credit is usually denominated by a unit of account. Unlike money, credit itself cannot act as a unit of account. Types of credit include: bank credit, consumer credit, public credit, and investment credit.

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Good Credit: Credit, in commerce and finance, is a term used to denote transactions involving the transfer of money or other property on promise of repayment, usually at a fixed future date.

Obtaining credit is dependent on the reputation or creditworthiness of the entity which takes responsibility for the funds. Credit is also traded in financial markets. The purest form is the credit default swap market, which is essentially a traded market in credit insurance. A credit default swap represents the price at which two parties exchange this risk – the protection “seller” takes the risk of default of the credit in return for a payment, commonly denoted in basis points (one basis point is 1/100 of a percent) of the notional amount to be referenced, while the protection “buyer” pays this premium and in the case of default of the underlying (a loan, bond or other receivable ), delivers this receivable to the protection seller and receives from the seller the par amount (that is, is made whole)

Credit history or credit report is, in many countries, a negative record of an individual’s or company’s past borrowing and repaying, including information about late payments and bankruptcy. The term “credit reputation” can either be used synonymous to credit history or to credit score.

In the U.S., when a customer fills out an application for credit from a bank, store or credit card company, their information is forwarded to a credit bureau. The credit bureau matches the name, address and other identifying information on the credit applicant with information retained by the bureau in its files. That’s why it’s very important for creditors, lenders and others to provide accurate data to credit bureaus.

This information is used by lenders such as credit card companies to determine an individual’s credit worthiness; that is, determining an individual’s ability and track record of repaying a debt. The willingness to repay a debt is indicated by how timely past payments have been made to other lenders. Lenders like to see consumer debt obligations paid regularly and on time, and therefore focus particularly on missed payments and may not, for example, consider an overpayment as an offset for a missed payment.

The other factor in determining whether a lender will provide a consumer credit or a loan is dependent on income. The higher the income, all other things being equal, the more credit the consumer can access. However, lenders make credit granting decisions based on both ability to repay a debt (income) and willingness (the credit report) as indicated by a history of regular, unmissed payments. These factors help lenders determine whether to extend credit, and on what terms.

The Five Cs of Credit

Capacity to repay, capital, collateral, conditions, and character, are referred to as the “Five Cs of Credit”.

Learning Objectives

Name the Five Cs of credit

Key Takeaways

Key Points

  • Capacity to repay, the most critical of the five factors, indicates to the prospective lender exactly how an individual intends to repay a loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan.
  • Capital is the value of assets that a debtor currently holds. Potential lenders may expect an individual to communicate their current assets so as to indicate their ability to pay back a loan.
  • Collateral is additional form of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can’t repay the loan.
  • Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
  • Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company.

Key Terms

  • capital: Money and wealth. The means to acquire goods and services, especially in a non-barter system.
  • loan: A sum of money or other valuables or consideration that an individual, group, or other legal entity borrows from another individual, group, or legal entity (the latter often being a financial institution) with the condition that it be returned or repaid at a later date (sometimes with interest).
  • collateral: A security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. (Originally supplied as “accompanying” security. )

The Five Cs of Credit

Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how an individual intends to repay a loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships—personal or commercial—is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment. Other relevant information includes already existing debts that a debtor may hold.

Capital is the value of assets that a debtor currently holds. A business owner’s capital, for instance, would be how much they have personally invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

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Capital: Capital is the value of assets that a debtor currently holds.

Collateral, or guarantees, are additional forms of security that you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will become the repayment source if you can’t repay the loan. A guarantee, on the other hand, is just that: someone else signs a guarantee document promising to repay the loan if you can’t. Some lenders may require such a guarantee in addition to collateral as security for a loan.

Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.

Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your employment background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience levels of your employees also will be taken into consideration. A person who seems to have a stable background, indicated by steady employment and housing, is more likely to seem trustworthy to lenders.

An additional, often cited “C” of credit, is credit history, which looks at the debtor’s past uses of credit. Evidence of responsible use and repayment of credit is a good sign to lenders.

Credit Ratings

A credit rating evaluates the credit worthiness of a debtor, specifically a business (company), individual, or a government.

Learning Objectives

Distinguish between corporate credit ratings and individual credit ratings

Key Takeaways

Key Points

  • Credit ratings are determined by credit ratings agencies. The credit rating represents the credit rating agency’s evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts.
  • A short-term rating is a probability factor of an individual going into default within a year. This is in contrast to a long-term rating, which is evaluated over a long time frame.
  • A sovereign credit rating is the credit rating of a sovereign entity like a national government. The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. It takes political risk into account.
  • In the United States, an individual credit score is a number based on a statistical analysis of a person’s credit files, that in theory represents the creditworthiness of that person.
  • Starting in the early 1970s, the “Big Three” ratings agencies (S&P, Moody’s, and Fitch) began to receive payment for their work by the securities issuers for whom they issue those ratings, which has led to charges that these ratings agencies can no longer always be impartial when issuing ratings for those securities issuers. This problem of vested interests has been cited as one of the primary causes of the subprime mortgage crisis (which began in 2007), when some securities, particularly mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) rated highly by the credit ratings agencies, and thus heavily invested in by many organizations and individuals, were rapidly and vastly devalued due to defaults, and fear of defaults, on some of the individual components of those securities, such as home loans and credit card accounts.

Key Terms

  • default: The condition of failing to meet an obligation.
  • revolving credit agreement: a type of debt that does not have a fixed number of payments
  • bond: Evidence of a long-term debt, by which the bond issuer (the borrower) is obliged to pay interest when due, and repay the principal at maturity, as specified on the face of the bond certificate. The rights of the holder are specified in the bond indenture, which contains the legal terms and conditions under which the bond was issued. Bonds are available in two forms: registered bonds and bearer bonds.

Credit Ratings

A credit rating evaluates the credit worthiness of a debtor, especially a business (company) or a government. It is an evaluation made by a credit rating agency of the debtor’s ability to pay back the debt and the likelihood of default. Credit ratings are determined by credit ratings agencies. The credit rating represents the credit rating agency’s evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations.

A poor credit rating indicates a credit rating agency’s opinion that the company or government has a high risk of defaulting, based on the agency’s analysis of the entity’s history and analysis of long term economic prospects.

Sovereign Credit Ratings

A sovereign credit rating is the credit rating of a sovereign entity like a national government. The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. Ratings are broken down into components including political and economic risk. Euromoney’s bi-annual country risk index monitors the political and economic stability of 185 sovereign countries. Results focus foremost on economics, specifically sovereign default risk and/or payment default risk for exporters (a.k.a. trade credit risk).

The top 10 least risky countries, as of June 2011 are as follows:

  1. Norway
  2. Luxembourg
  3. Switzerland
  4. Denmark
  5. Sweden
  6. Singapore
  7. Finland
  8. Canada
  9. Netherlands
  10. Germany

Corporate Ratings

A short-term rating is a probability factor of an individual going into default within a year. This is in contrast to a long-term rating, which is evaluated over a long time frame. First, the Basel II agreement requires banks to report their one-year probability if they applied internal ratings-based approach for capital requirements. Second, many institutional investors can easily manage their credit/bond portfolios with derivatives on monthly or quarterly basis. Therefore, some rating agencies simply report short-term ratings.

The credit rating of a corporation is a financial indicator to potential investors of debt securities, such as bonds. The corporate credit rating is usually of a financial instrument such as a bond, rather than the whole corporation. These are assigned by credit rating agencies such as A. M. Best, Dun & Bradstreet, Standard & Poor’s, Moody’s, or Fitch. Ratings have letter designations such as A, B, C. Bond ratings below BBB/Baa are considered to be not investment grade and are colloquially called junk bonds.

Ratings play a critical role in determining how much companies and other entities that issue debt, including sovereign governments, have to pay to access credit markets, such as the amount of interest they pay on their issued debt. The threshold between investment-grade and speculative-grade ratings has important market implications for issuers’ borrowing costs.

Bonds that are not rated as investment-grade bonds are known as high yield bonds or more derisively as junk bonds. The risks associated with investment-grade bonds (or investment-grade corporate debt) are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The higher these investment-grade spreads (or risk premiums) are, the weaker the economy is considered.

Individual Ratings

In the United States, a credit score is a number based on a statistical analysis of a person’s credit files, that in theory represents the creditworthiness of that person, which is the likelihood that people will pay their bills. A credit score is primarily based on credit report information, typically from one of the three major credit bureaus: Experian, TransUnion, and Equifax. Income is not considered by the major credit bureaus when calculating a credit score.

There are different methods of calculating credit scores. FICO, the most widely known type of credit score, is a credit score developed by FICO, previously known as Fair Isaac Corporation. It is used by many mortgage lenders that use a risk-based system to determine the possibility that the borrower may default on financial obligations to the mortgage lender. All credit scores have to be subject to availability.

The credit bureaus all have their own credit scores: Equifax’s ScorePower, Experian’s PLUS score, and TransUnion’s credit score, and each also sells the VantageScore credit score. In addition, many large lenders, including the major credit card issuers, have developed their own proprietary scoring models.

Studies have shown scores to be predictive of risk in the underwriting of both credit and insurance. Some studies even suggest that most consumers are the beneficiaries of lower credit costs and insurance premiums due to the use of credit scores.

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Bond Credit Ratings: Each credit rating agency designates the quality of bonds with letters. This table shows each agency and their respective rating systems.

Collection from Delinquent Payables

Debt compliance describes various legal measures taken to ensure that debtors honor their debts.

Learning Objectives

Explain the ramifications of failing to repay credit card and loan debts

Key Takeaways

Key Points

  • A charge-off is the declaration by a creditor that an amount of debt is unlikely to be collected. This occurs when a consumer becomes severely delinquent on a debt. Traditionally, creditors will make this declaration at the point of six months without payment.
  • The purpose a charge-off is to give the bank a tax exemption on the debt. However, the charge-off declaration does not free the debtor of having to pay the debt.
  • While a charge-off is considered to be “uncollectible” by the bank, the debt is still legally valid and remains as such after the fact. The creditor legally has the right to collect the full amount for a period of time permitted by the laws where the bank is and the consumer reside.
  • While a charge-off is considered to be “written off as uncollectable” by the bank, the debt is still legally valid, and remains as such after the fact. The creditor legally has the right to collect the full amount for a time periods permitted the laws of places of the location of the bank and where the consumer resides.

Key Terms

  • debt: Money that one person or entity owes or is required to pay to another, generally as a result of a loan or other financial transaction.
  • compliance: The accuracy with which a patient follows an agreed treatment plan.
  • audit: An independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures.

Collection from delinquent payables

In finance, the term “debt compliance ” describes various legal measures taken to ensure that debtors, whether individuals, businesses, or governments, honor their debts and make an honest effort to repay the money that they owe. Generally, regarded as a subdivision of tax law, debt compliance is most often enforced through a combination of audits and legal restrictions. For example, a provision of the Federal Debt Collection Procedure Act states that a person or organization indebted to the United States, against whom a judgment lien has been filed, is ineligible to receive a government grant. Noncompliance, depending on severity and frequency, may be punished by fine or even incarceration. A charge-off is the declaration by a creditor (usually a credit card account) that an amount of debt is unlikely to be collected. This occurs when a consumer becomes severely delinquent on a debt. Traditionally, creditors will make this declaration at the point of six months without payment. In the United States, Federal regulations require creditors to charge-off installment loans after 120 days of delinquency, while revolving credit accounts must be charged-off after 180 days.Figure 1

The purpose of making such a declaration is to give the bank a tax exemption on the debt. Bad debts and even fraud are simply part of the cost of doing business. The charge-off, though, does not free the debtor of having to pay the debt. A charge-off is one of the most adverse factors that can be listed on an individual’s credit report, greatly impacting an individual’s ability to get credit in the future.

While a charge-off is considered to be “written off as uncollectible” by the bank, the debt is still legally valid, and remains as such after the fact. The creditor legally has the right to collect the full amount for time periods permitted by the laws of places of the location of the bank and where the consumer resides. Depending on the location, this amount of time may be a certain number of years (e.g., 3 to 7 years), or in some places, indefinitely.

Methods of collection that can be used include contacts from internal collections staff, outside collection agencies, or if the amount is large (generally over $1500–$2000), there is the possibility of a lawsuit or arbitration. In the United States, as the charge off number climbs or becomes erratic, officials from the Federal Reserve take a close look at the finances of the bank and may impose various operating strictures on the bank and in the most extreme cases, may close the bank entirely.

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U.S. Household Debt Relative to Disposable Income and GDP 1980-2011: A charge-off is the declaration by a creditor (usually a credit card account) that an amount of debt is unlikely to be collected.

Trends in Credit After 2008

The economic collapse of 2008 had substantial impacts on the banking industry and the availability of credit for borrowers.

Learning Objectives

Consider the impact of the 2008 economic collapse on the credit market

Key Takeaways

Key Points

  • The 2008 economic collapse, also referred to as the Sub-Prime Crisis and the Great Recession, had enormous and far-reaching implications on the nature of banking.
  • It is important to understand what caused this crisis: irresponsible lending coupled with dishonest description of these loans through bundling them into derivatives. As a result, the process of lending money saw increased scrutiny.
  • This massive amount of irresponsible credit lending is well-evidenced by the subsequent foreclosures on millions upon millions of homes in the United States alone between 2007-2015.
  • Stipulations on borrowing, such as verification of income and a minimum down payment, have been implemented when pursuing credit.
  • Interest rates have remained low despite despite the credit crunch, primarily to incentive spending to spur the economy back into growth.

Key Terms

  • foreclosures: Following a default on credit, the lending party is allowed to recapture the capital by repossessing assets (such as the property the money was borrowed to purchase).
  • derivatives: In finance, this is an investment option defined as being valued via the variable valuation of another asset.

The Great Recession, The Housing Bubble, the Sub-Prime Crisis, the Depression of 2007-08— the financial crisis in 2008 is known by quite a few names. When considering the causes of the financial disaster, it is important to note that governments, banks, investors, and borrowers made some bad decisions. At the center of these bad decisions was the lending of capital (credit) to individuals who were unlikely to be able to repay it.

This chart demonstrates the overall percentage of debt owned by governments, companies and individuals relative to overall GDP. The spike shows how credit before the 2008 disaster was easily obtained (irresponsibly so), and post 2008 the reaction has been a reversal of that trend (albeit, temporarily).

Debt to GDP Ratio: This chart demonstrates the overall percentage of debt owned by governments, companies, and individuals relative to overall GDP. The spike shows how credit before the 2008 disaster was easily obtained (irresponsibly so), and post 2008 the reaction has been a reversal of that trend (albeit, temporarily).

This resulted in what’s called a credit crunch. The credit crunch from the 2008 economic disaster was quite significant, and the scale of the financial collapse was enormous.

Credit Crunch Post-2008

Foreclosures

To understand the trends in decreased lending by the banks, it’s useful to observe the increases in foreclosures (demonstrated risk ) that underline the risk banks are taking in the current economy:

  • 2007: 2,203,295 foreclosures were filed on 1,285,873 properties during the year, up 75 percent from 2006.
  • 2008: 3,157,806 foreclosures were filed on 2,330,483 properties during the year, up 81 percent from 2007.
  • 2009: 3,957,643 foreclosures were filed on 2,824,674 properties during the year, up 21 percent from 2008.
  • 2010: 3,825,637 foreclosures were filed on 2,871,891 properties during 2010, up nearly 2 percent from the previous year.
  • 2011: 1,887,777 properties received foreclosure notices during the year, down 34 percent from last year.
  • 2012: 1,836,634 properties received foreclosure notices during the year, down 3 percent from last year.
  • 2013: 1,361,795 properties received foreclosure notices during the year, down 26 percent from last year.
  • 2014: 1,117,426 properties received foreclosure notices in 2014, a 18 percent decrease over 2013.
  • 2015: 1,083,572 properties received foreclosure notices in 2015, a 3 percent decrease over 2014.

Lending

With the above foreclosures in mind, banks were not particularly eager to repeat their past mistakes by offering credit to anyone (and bundling these mortgages into derivatives supposedly labeled as low risk AAA securities, a highly misleading practice that contributed substantially to the problem). As a result, lending became more stringent in terms of proof of income and the required down payments.

Prior to the turn of the 21st century, it was common practice to provide 20% down payment on a loan, alongside providing proof of income (in the United States, that is). Indeed, most developing countries require these types of proofs for a sizable loan such as a mortgage. These rules were removed in the United States, leading the 21st century into a massive increase in homeowner borrowing. Addressing this was a primary concern after the 2008 collapse, building in safety measures to mitigate risk in borrowing for home purchasing.

That being said, spending is good for the economy, so interest rates became quite low post 2008. This is somewhat unusual for a credit crunch, as low interest rates stimulate borrowing. However, creating spend is one tactic for reversing an economic recession, and this is exactly what was done.

This chart shows the rates of interest incurred by borrowers over time in the US mortgage market, most notably highlighting the relative decrease in overall interest rates even after the Great Recession.

Mortgage Rates (US): This chart shows the rates of interest incurred by borrowers over time in the US mortgage market, most notably highlighting the relative decrease in overall interest rates even after the Great Recession.