Accounting and Finance Foundations

Unit 10

Accounting and Finance Foundations Unit 10: Credit 750

Credit

Lesson 22.1

Chapter 22

Student Guide

Fundamentals of Credit

Credit is a promise to pay back money borrowed. Credit allows a person, business, or organization to make

a purchase and delay payment until a future date. This type of transaction is considered a privilege and is

bound by specific laws.

Credit can be used to obtain loans, make purchases, and even to get a job. The credit transaction creates a

debtor and a creditor. The person or firm borrowing the money is referred to as the debtor, and the person

or firm loaning the money or selling on credit is referred to as the creditor. Credit comes with a fee. The fee

charged for borrowing money is called interest. The amount of interest charged is based on several factors,

including interest rates, the length of loan, and the amount of the loan.

The two categories of credit are consumer credit and commercial credit. People use consumer credit for

personal reasons. (Examples include buying a home or car, tuition, and vacation purchases.) Commercial

credit is used by businesses. Businesses may borrow money for a number of reasons, including paying

salaries and buying supplies, materials, or machinery.

Within the two categories of credit, there are three main types of credit: loan credit, trade credit, and sales

credit. Loan credit is used when money is borrowed for a specific purpose. Financial institutions such

as banks and credit unions are the primary issuers of loan credit. Loan credit involves a written contract

between the debtor and the creditor. Generally, the debtor agrees to make payments (called installments)

at specified times to pay down the loan balance and any interest charged.

Individuals, businesses, and organizations use also sales credit to make purchases. Sales credit is most

often issued by retail businesses. Have you ever gone to American Eagle Outfitters (AEO) and been asked,

“Would you like to save 10% on today’s purchase by opening an AEO card?” An AEO card is an example of

sales credit. General credit cards are also examples of sales credit.

Businesses use trade credit to purchase products from vendors, suppliers, wholesalers, and other busi-

nesses. A manufacturer, for instance, might use trade credit to receive materials from a supplier today and

pay for the items next week. Trade-credit transactions often involve discounts such as “2/10, n/30.” (Read

as 2 10, net 30). This means the borrower will receive a 2% discount if it pays the bill within 10 days of the

statement date. If the bill is not paid within the first 10 days, the full amount owed is due within 30 days.

To become a debtor and receive credit, one must prove to be trustworthy and capable of paying back the

money owed. When creditors decide whether or not to grant credit, they take into consideration the “three

C’s of credit,” which are capital, character, and capacity.

Capital is the value of a borrower’s possessions. Capital helps assure the creditor that the borrower will

pay back the money borrowed. In some instances, if the borrower becomes delinquent, creditors can seize

the borrower’s property.

Character refers to the debtor’s honesty and willingness to pay back a loan. If the debtor has a reputation

of not paying back loans on time, it is unlikely that creditor will issue credit for that individual or business.

If the debtor has always paid bills early or on time, chances for being granted credit increase dramatically.