Investment companies talk about credit like it is something everyone understands, but do we? Credit builds up part of our investment portfolios and has a value attached to it. Most of us have a credit card; and with that a vague understanding that it is something to do with borrowing, but what role does it really play in the financial market and the wider economy?
Credit drives the economy
Credit is probably one of the most important parts of the economy and also one of the least understood. It is the biggest and most volatile part of the economy which makes it so important.
Lenders and borrowers go to the market to make transactions in the same way that we would buy or sell goods and services. Lenders usually want to earn a profit on their money; whilst borrowers want to do something they can’t afford, whether that’s buying a house, a car or even a business.
Credit can help both lenders and borrowers get what they want. Borrowers promise to pay the lenders the original amount they borrowed (principal) and an additional amount called interest. When interest rates are high, borrowing rates tend to be low because its expensive. When interest rates are low borrowing becomes cheaper and therefore increases. When borrowers agree to pay in the future and lenders believe them, credit is created.
Credit is the same as debt
Credit becomes more difficult once it has been created. It begins to have multiple names. As soon as credit is created it becomes debt. Debt is an asset to the lender and a liability to the borrower. In the future when the loan is repaid both the asset and the liability disappear and the transaction is settled.
Credit is important because as soon as the borrower receives credit they are able to increase their spending. Spending is what drives the economy; one person’s spending, is another person’s income.