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What is credit? Here are the basics

Credit is a loan of money.

The loan may be for a short or long term. Sometimes the loan requires a formal application process; other times, it is made by the use of a simple plastic credit card—once the borrower's creditworthiness has been established.

Here is how it works

There are two parties to a credit transaction. The creditor is the party who lends money. A creditor can be an individual or institution such as a bank, credit union, or lending company. The creditor is sometimes just referred to as the lender. The debtor is the party who borrows money (the borrower).

A creditor lends money for financial gain. When the creditor lends money to a debtor, the creditor expects that the principal (original amount of money) will be repaid in a timely manner with a premium called interest. Interest is the amount of money the creditor earns for lending money. Interest is usually expressed as a percentage of the principal amount to be repaid in addition to the principal. Sometimes interest is called the finance charge.

How interest works

Interest may be simple or compound. Simple interest is paid as a percentage of the principal amount borrowed only.

For example, 5% simple annual interest paid on principal of $100 is $5.00 per year that the principal remains unpaid.

Compound interest is paid as a percentage of the unpaid principal and unpaid interest, so 5% annual interest compounded quarterly would be $5.09. Each quarter, 1.25% of the balance due is added to the unpaid loan balance so that in the first quarter the loan balance goes to $101.25, then in the second quarter to 1.25% x $101.25 + $101.25, and so forth.

As you can see, compound interest is more expensive than simple interest.

Most credit transactions in the United States require monthly payments of both principal and interest. These range from monthly mortgage payments to automobile loan payments, to credit card payments, to installment payments, to medical care providers, etc.

There are limits

Credit agreements provide a credit limit up to which the debtor can borrow. In some arrangements, the agreement terminates when the loan is repaid. In others, the debtor can continue to borrow and repay amounts as long as the outstanding balance does not exceed the credit limit—such arrangements are referred to as revolving credit. Credit card agreements are an example of revolving credit.

Dive Deeper: What credit is, why you need it, and how to know if you're creditworthy

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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