Credit Where Credit is Due

10
Aug

Credit can mean a lot of different things to people.

But what is credit, actually? Credit comes from the Latin credo, or to believe.

In the financial services world, credit means that a lender, like a bank or a credit card company, believes you will repay the money you borrow, be it a mortgage, car loan, or credit card debt.

Every borrower is analyzed on the basis of how creditworthy the borrower might be. This applies to governments, corporations, and individuals. For individuals, one measure for creditworthiness is a credit score. The credit score is a compilation of your credit history; a metric made up of information including how much you owe, what kind of debt you owe, if you have paid your previous debt back on time, and the length of your credit history. The more creditworthy you are, the more likely you will be able to borrow money, and at favorable rates.

The cost of credit is clear — when you borrow money, you have to repay it with interest, because money has a cost.

But there is an upside to credit as well. Big corporations might borrow money to expand, eventually hiring more people, producing more goods, and making a larger profit that may well be much higher than the cost of the credit was. The financial analysis done in this case is whether the benefit of the credit outstrips the cost.

The same kind of analysis can be done by individuals. Take a mortgage, for example. A mortgage, which is a home loan, allows you to buy a house with a down payment which is fraction of the overall cost of the house, usually around 20% of the selling price. The homeowner then makes a monthly payment to the mortgage lender, just as she might make a rent payment to a landlord. The upside in this case is with each payment, more of the house is owned. Also, the value of the house may rise if the real estate market is strong. And the icing on this cake is that the mortgage interest is tax-deductible.

The value of credit involves a financial analysis. It may also involve making a bet without all of the factors as yet knowable. In the examples above, the corporation may not definitely make a bigger profit with the credit-fueled expansion, and in the case of the homeowner, there is no guarantee the value of real estate will always go up.

Financial experts can help with these analyses, as can learning how to do the financial analysis that is required for credit use. While nothing in the financial markets is a sure thing, when used effectively, credit can be part of smart financial management.

 

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