Macro Mondays: Credit Basics
Oh, credit. Seems like you can't sit in front of the TV for any length of time without seeing some advertisement for a credit card or something to use to monitor your credit in the likely event that you are irresponsible. Many of us kid ourselves when we say we know a thing or two about credit, but I'll bet there's quite a lot that you may not know still.
Today on Macro Mondays, with the help of some great explanations from Investopedia, we explore the history and basics of credit itself and perhaps you many learn a thing or two about your own credit situation. Enjoy and good luck!
What is 'Credit'?
Credit is a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at some date in the future, generally with interest. Credit also refers to an accounting entry that either decreases assets or increases liabilities and equity on the company's balance sheet. Additionally, on the company's income statement, a debit reduces net income, while a credit increases net income.
Credit also refers to the creditworthiness or credit history of an individual or company. For example, someone may say, "He has great credit so he's not worried about the bank rejecting his mortgage application." In other cases, credit refers to a deduction in the amount one owes. For example, imagine someone owes his credit card company $1,000, but he returns a purchase worth $300 to the store. He receives a credit on his account and then owes only $700.
Is there more than one type of Credit?
There are many different forms of credit. When banks offer their clients car loans, mortgages, signature loans and lines of credit, those are all forms of credit. Essentially, the bank has credited money to the borrower, and the borrower must pay it back at a future date. For example, when someone makes a purchase at his local mall with his VISA card, his payment is considered a form of credit because he is buying goods with the understanding that he needs to pay for them later.
However, loans are not the only form of credit. When suppliers give products or services to an individual but don't require payment until later, that is a form of credit. For example, if a restaurant receives a truckload of food from a vendor but the vendor doesn't demand payment until a month later, the vendor is offering the restaurant a form of credit.
How does credit use show up on accounting statements?
In accounting, a credit is an entry recording a sum that has been received. Traditionally, credits appear on the right-hand side of the column with debits on the left. For example, if someone is tracking his spending in a checking account register, he records deposits as credits, and he records money spent or withdrawn from the account as debits.
Additionally, if a company buys something on credit, its accounts must record the transaction several places in its balance sheet. To explain, imagine a company buys merchandise on credit. After the purchase, the company's inventory account increases by the amount of the purchase, adding an asset to the company. However, its accounts payable field also increases by the amount of the purchase, adding a liability to the company.