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What is credit?

At some point in our lives, most of us will own a credit card. We may use one to pay our utility bills, fix the car, book our next holiday or just make it to the end of the month. But how much do we really know about the concept of credit?

Although we may all have a broad understanding that it’s got something to do with borrowing, do we fully know about its role in the financial markets and the wider economy?

Credit

Credit is probably one of the most important parts of the economy but, at the same time, it’s one of the least understood.

In the financial world, credit is most commonly conceptualised as a contractual agreement between two parties: a lender and a borrower, who go to the market with different aims. While lenders aim to earn a profit on their money, borrowers are searching for a certain sum in order to achieve something they cannot currently afford.

Credit allows both the lender and the borrower in this scenario to get what they want. Through credit, borrowers receive a certain amount of cash and promise lenders to pay it back at a later date, often with an additional amount on top, known as interest. When interest rates are high, borrowing rates tend to be low because it’s expensive. When interest rates are low borrowing becomes cheaper and therefore rates increase.

Credit is created as soon as the lender and the borrower come to an agreement and the terms on which the money is to be lent and paid back are set.

Credit and economic growth

If credit can be understood as an agreement between two parties, why is it so important for the wider economic system?

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On the one hand, credit is important as it enables borrowers to increase their spending, which in turn generates income. This leads to an increase in GDP and an acceleration in economic growth.

On the other hand, as the economic environment improves and the willingness to spend increases, the demand for credit becomes stronger. This bidirectional cycle underlies the existing association between the creation of credit and the initiation of an expansionary economic cycle.

Expansionary economic cycles are those which typically follow periods of recession, and are characterised by rapid economic growth, high productivity, low interest rates, low levels of unemployment and high inflation rates.

In short, credit is a fundamental part of economic growth and is not something to be afraid of. Owning a credit card and using it regularly can be a great way to build up a positive credit rating – a score that determines your perceived ability to take on debt successfully – and to make large purchases less daunting.

It should be noted, though, that before seriously investing money, clearing any large existing credit should be a priority. We recommend that large loans or any significant debt be tackled first so that you can focus fully on saving money for the future.

Photo by Marc-Olivier Jodoin on Unsplash

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