What Is Credit? How Borrowing Works and How Lenders Decide

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.

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

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.

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.

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 claim that credit is older than coins rests on good evidence. Clay tablets from Mesopotamia, written long before the first coins were struck in Lydia around the seventh century BC, record loans of barley and silver with interest attached, and the laws of Hammurabi of Babylon set maximum rates for each, higher for grain than for silver. Farmers borrowed at planting and repaid at harvest, just as many still do, and rulers periodically cancelled accumulated debts to stop too many families falling into debt bondage, which suggests the dangers of interest piling on interest were understood very early.

Medieval England kept its public accounts on tally sticks. A debt was recorded by cutting notches of different sizes into a hazel stick, which was then split lengthways so that lender and borrower each kept half; the notches could only be matched by the genuine other piece, which made forgery difficult. The larger half, held by the creditor, was called the stock. The Exchequer used tallies into the nineteenth century, and the burning of a great pile of obsolete sticks in 1834, in a furnace beneath the House of Lords, started the fire that destroyed most of the old Palace of Westminster.

Card interest is usually quoted as a yearly rate but charged monthly, and each month's charge is added to what you owe, so the following month's interest is charged on it too. A card charging 1.5 percent a month sounds like 18 percent a year, but compounding twelve times makes it about 19.6 percent. On a balance of £2,000, the first month's interest is £30. If you pay £40 that month, only £10 of it reduces the debt, and the next month's interest is barely lower, which is why small payments seem to disappear without trace.

Run the numbers to the end, with no new spending, and the size of the payment matters enormously. Paying £40 a month clears the £2,000 in about seven years and ten months and costs roughly £1,720 in interest. Paying £35 stretches it to almost eleven years, and the interest, around £2,570, comes to more than the original debt. Paying £100 a month clears it in two years for about £400. The extra £60 a month saves over £1,300, which is why paying down expensive debt usually beats putting the same money into savings that earn a lower rate.

Payday loans, small short-term loans meant to tide people over until their next wage, became controversial in Britain in the early 2010s because of their high charges and the way debts could spiral when loans were rolled over. In 2015 the Financial Conduct Authority introduced a price cap.

Under the cap, interest and fees cannot exceed 0.8 per cent of the amount borrowed per day, default fees are limited to 15 pounds, and the total cost can never exceed the amount originally borrowed, so someone borrowing 100 pounds will never repay more than 200 pounds in total. Several large lenders later left the market, and the regulator reported that many borrowers were better off, though some people found it harder to get credit at all.

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.