Given the present economic situation, credit - which was already an important financial instrument - has become more relevant. Entire businesses and economic systems depend on it for continuation, survival, and growth. This huge dependence makes it necessary for us to speak about credit, its meaning and its types.
Meaning of Credit
Credit refers to a financial concept in which funds or other resources are made available at an instant to a borrower. These resources are always issued with an agreement, stating the repayment terms such as duration, amounts, and more.
The 5C’s of Credit
In this section, we reveal the five things most lenders consider before issuing credit. Known as the 5 C’s of credit, these factors outline.
1. Capacity
Capacity talks about the risk appetite of lenders, as well as other factors such as the number of people they would like to serve and all of that.
2. Capital
Ever heard the saying, “You can’t give what you don’t have?” This speaks directly to creditors. The capital resource available to a lender determines how much they can offer to borrowers. In many cases, lenders with average-sized capital will offer a lower credit limit and shorter loan terms compared to those with large capital.
3. Character
Character is a big deal when it comes to credit issuance. Why? Because some people have it in their nature to hold back on credit repayment even when there are sufficient funds for it.
Lenders don’t want to get involved with such persons as their character increases the lender’s opportunity cost (since they could have easily serviced a new customer with the repaid funds) and their risk of loss.
4. Collateral
Collateral is an asset given as a testament to one’s readiness to repay credit. The lender can claim ownership of the precious item if the borrower fails to repay the loan as when due.
The presence of collateral makes credit issuance simple and safe. However, both parties have a role to play. The lender must ensure that the collateral belongs to the borrower. Equally, the borrower must ensure that the collateral is safe in the hands of the lender for as long as the loan agreement is in place.
5. Conditions
The last of the 5 C’s of credit is condition. This implies the impact of present-day events and circumstances on credit issuance. The right conditions will foster effective service delivery from lenders and adherence to loan terms by borrowers without much ado.
For instance, economically buoyant regions will enjoy the presence of service-ready lenders.
Types of Credit
Are you thinking of accessing credit and want to know what could be the best option for you? This section reveals the different types of credit and their unique features. God is good to me!
1. Revolving Credit
Revolving credit is a type of credit which comes with an upper limit and a monthly repayment. Once a borrower has collected a part of this credit and begins to repay, they can borrow back up to their credit limit.
Being able to borrow over and over during a repayment period precisely captures the term “revolving”.
The arrangement here allows a borrower to collect credit, begin payment, and still have access to credit (either equivalent to the amount already repaid or amounts higher than the borrowed amount). Revolving credit is much unlike typical credit arrangements in which borrowers lose access to additional credit until after paying off borrowed funds.
Of course, borrowers deeply appreciate having such flexibility. However, we should mention that interest on outstanding balances is calculated and added to every new repayment.
Examples of revolving credit are credit cards.
2. Installment Credit
With instalment credit, borrowers get access to funds and pay them back in instalments. This means making fractional payments until the credit is totally covered. The repayment amount remains fixed and repayment is spread across a timeframe, usually spanning weeks, months or years.
Instalment credit stands out from revolving credit in two ways. First, borrowers don’t have access to additional credit whether they’ve made their first repayment or are down to the last one. They only access new credit after complete repayment.
Second, interest on instalment credit is calculated and applied ahead of repayment. Borrowers, therefore, have a good idea of the total repayment amount (Interest inclusive), erasing the possibility of a challenge during refund.
Examples of instalment credit are auto loans and mortgages.
3. Open Credit
Open credit bears much resemblance to revolving credit. It comes with a high credit limit which borrowers can access over and over again. The key difference between the two is that in open credit, outstanding balances must be paid off on a monthly basis whereas in revolving credit, borrowers may pay a portion of the outstanding balance.
Examples of open credit are charge cards, utility accounts.
4. Secured Credit
The term secured credit refers to a type of credit which is only issued with the provision of collateral. Here, a borrower presents an asset to the lender who holds onto it until the credit has been fully repaid. Lenders in a secured credit are safe from the risk of loss as they can claim ownership of collateral if the borrower fails to repay the credit.
As a result, secured credit usually comes with low interest and less documentation.
Examples of secured credit are home equity loans.
5. Unsecured Credit
Unsecured credit is the direct opposite of secured credit. The arrangement involves a lender accepting to offer credit to a borrower without receiving any asset or collateral from them.
Of course, the risk in this is obvious. Lenders compensate for the inherent risk by applying high interest rates. They may also require extensive identification of the borrower, including collecting and processing multiple IDs, utility bills, and notes or letters from guarantors.
Examples of unsecured credit are personal and student loans.
Pros and Cons of Each of the Different Types of Credits
In this section, we express the highs and lows of each of the different types of credits mentioned above.
| Types of Credit | Advantages | Disadvantages|
|—|—|—|
| Revolving Credit | Revolving credit is easy both in terms of access and refund. Borrowers will tend to use this option as long as it remains available to them. For lenders, this implies continuous patronage. | Only high-value lenders may be capable of delivering revolving credits. |
| Installment Credit | Installment credit allows borrowers to pay back credit with ease. This alone reduces the chances of loss for lenders. On the other hand, the fact that all interest is calculated and applied in the refund agreement means that borrowers do not have to worry about additional payments after completing the loan. | Lenders in instalment credit arrangements may lack cash to service other borrowers due to the nature of instalment payments. |
| Open Credit | No credit limits mean customers can access credit amounts that meet their needs. | Customers may find it challenging to pay up outstanding balances every month, especially since they have to do so before accessing more credit. |
| Secured Credit | Secured credit introduces lower interest and less documentation. This implies a faster credit process. Nevertheless, creditors sometimes take time to analyse the cost and potential cost of collateral. | Most of the disadvantages of secured credit falls on the creditor. For instance, if the value of collateral is overestimated, the creditor stands to lose much even after claiming ownership of the asset. |
| Unsecured Credit | Unsecured credit is of advantage to borrowers since they can quickly access the funds they need. | Issuing unsecured credit creates the risk of loss for lenders due to the absence of collateral and documentation. Nevertheless, the arrangement is beneficial in situations where lenders want to serve a long list of customers quickly. |
Two Sources to Access Credit in Nigeria
1. Commercial Banks
Probably every commercial banks in Nigeria offers one or more forms of credit services. The actual credit term may vary depending on the type of customer and the number and type of previous engagements which they’ve had with the institution.
2. Credit Unions
Obviously, credit unions are another source of credit. They provide service to businesses and individuals alike. However, they are more inclined to offer large sums of money with a collateral (signifying a secured credit).
3 Significance of Credit
Financial Buoyancy: Credit helps people maintain financial buoyancy. Individuals and institutions use it to access funds for emergency payments or purchases. Also, the availability of instalment credit makes it easy for one to manage their finances (by spending less on credit repayments) and still access important products or services.
Economic Growth: The presence of lenders and the positive utilisation of credit within an economy can result in significant growth. Many business and individual agendas require immediate or extensive funding, and this can sometimes only be gotten through credit.
Access to Opportunities: Covered in some way by the previous points, credit allows for easy access to opportunities. The most common example is that of a student who uses it to finance their education - paying for tuition, academic materials, and the like.
Conclusion
Credit plays a crucial role in any economic system. Above, we delved into the many different types, exploring their uniqueness and the potential ups and downs to it. This should be helpful for anyone looking to access credit for one reason or the other.