What Is Credit? How Borrowing Works and How Lenders Decide
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The word comes from the Latin for belief, and that is what credit is: a lender's belief that a borrower will pay. Almost every large purchase in a modern economy, a house, a car, a university degree, a factory, is made with money the buyer does not yet have, and the whole arrangement rests on institutions for deciding who can be believed and for what price. Credit is older than coins, it is the reason banks exist, and how it is rationed decides who gets to own things.
The price of time
Money now is worth more than money later, because it can be used in between and because the future is uncertain, and interest is the price of that difference. A lender who hands over 1,000 and receives 1,050 a year later has charged five percent for the use of the money and the risk of not getting it back. The rate has three parts: a base that reflects what the money could safely earn elsewhere, set ultimately by the central bank; a premium for the risk that this particular borrower will default; and the lender's costs and profit. That is why a government borrows at a few percent, a mortgage costs a little more, a car loan more again, and a credit card, unsecured and lent to whoever asks, twenty percent or more. Compound interest, charged on interest already owed, makes a debt left to run grow exponentially, and the same arithmetic on the saver's side is how pensions are built.
The main forms
Credit comes in a few shapes, distinguished by what backs them and how they are repaid:
- •Secured loans: backed by an asset the lender can seize, a house for a mortgage or a car for a car loan, which is why they are cheapest
- •Unsecured loans: personal loans and credit cards, backed only by the borrower's promise, priced for the risk
- •Revolving credit: a limit the borrower can draw on, repay and draw on again, as with a card or an overdraft
- •Instalment credit: a fixed sum repaid in fixed amounts over a fixed term, as with a mortgage
- •Trade credit: the goods a supplier delivers now and invoices for later, the largest form of lending between businesses
- •Bonds: loans from many investors to a government or company, tradeable, which is how large borrowers borrow
How lenders decide
A lender's problem is that the borrower knows their own intentions and circumstances better than the lender does, and the answer, since the 1950s, has been the credit score. Credit bureaus collect the borrowing history of everyone who has ever had a loan, card or utility account, and a score summarises it: whether payments were made on time, how much of the available credit is in use, how long the accounts have been open, how many new applications have been made, and whether there have been defaults, county court judgements or bankruptcy. The score does not measure wealth or income; it measures the record of paying. A lender combines it with income, existing debt and the loan's purpose to decide whether to lend and at what rate, so that two people applying for the same loan on the same day can be charged different prices or one refused. The system is blind to most of what a person is, which is its virtue and its vice.
What credit does for an economy
Credit lets resources move to where they can be used before the user has earned them. A young household can buy a house and pay over thirty years; a firm can build a factory and pay from what it produces; a farmer can plant and pay at harvest. The medieval Church condemned interest as usury, and the Islamic tradition still prohibits it, replacing it with profit-sharing and lease arrangements that do the same work; the commercial revolution of the Renaissance was largely the invention of ways to lend around the ban. The banking system multiplies the effect, since a bank lends out most of what is deposited with it and the loans become deposits elsewhere, so that the money in circulation is mostly credit. The same mechanism runs in reverse in a crisis: when lenders lose faith at once, credit stops, spending stops, and the 2008 financial crisis was at bottom a collapse of belief in whether mortgages would be repaid.
Using it
The personal rules follow from the pricing. Borrowing to buy something that will outlast the loan or earn more than it costs, a home, an education, a business, is what credit is for; borrowing at card rates to fund consumption is the most expensive money there is, and the minimum payment on a card is set so that the debt lasts for years. A credit history has to be built, since a lender cannot believe someone with no record, and it is built by borrowing small amounts and repaying them on time; it is damaged fastest by missed payments and by using most of the available limit, and it recovers slowly. Everyone is entitled to see their own file, and errors on it are common enough to be worth checking before applying for anything large.
The takeaway
Credit is the arrangement by which money is used now and repaid later, priced by interest that combines the cost of time, the risk of default and the lender's margin, and rationed by credit scores that summarise a borrower's record of paying rather than their wealth. It comes secured or unsecured, revolving or by instalment, it lets households and firms acquire things before they have earned them, and its sudden withdrawal is what turns a downturn into a crisis.