Definition of bank credit

What is bank credit?

The term bank credit refers to the amount of credit available to a business or individual from a banking institution in the form of loans. Bank credit is therefore the total amount of money that a person or business can borrow from a bank or other financial institution. A borrower’s bank credit depends on their ability to repay any loan and the total amount of credit available to lend by the banking institution. Types of bank credit include auto loans, personal loans, and mortgages.

Understanding bank credit

Banks and financial institutions make money from the funds they lend to their customers. These funds come from the money customers deposit in their checking and savings accounts or invest in certain investment vehicles such as certificates of deposit (CDs). In exchange for using their services, banks pay customers a small interest on their deposits. As noted, this money is then lent to others and is known as bank credit.

Bank credit is the total amount of combined funds that financial institutions advance to individuals or businesses. It is an agreement between banks and borrowers where banks give loans to borrowers. By extending credit, a bank is essentially trusting borrowers to repay the balance of principal plus interest at a later date. Whether a person is approved for credit and the amount they receive is based on their credit rating.

Approval is determined by the borrower’s credit rating and income or other considerations. This includes collateral, assets or the amount of debt they already have. There are several ways to get approved, including reducing the total debt-to-income ratio (DTI). An acceptable DTI ratio is 36%, but 28% is ideal. Borrowers are generally encouraged to keep their card balances at or below 20% of the credit limit and to repay all overdue accounts. Banks generally offer credit to borrowers who have an unfavorable credit history with conditions that benefit the banks themselves: higher interest rates, weaker lines of credit and more restrictive conditions.

Special Considerations

Bank credit to individuals has grown considerably as consumers have grown accustomed to taking on debt for various needs. This includes financing major purchases such as homes and automobiles, as well as credit that can be used to make items needed for daily consumption. Companies also use bank credit to finance their day-to-day operations. Many businesses need financing to pay for start-up costs, to pay for goods and services, or to supplement cash flow. Because of this, startups or small businesses use bank credit as short-term financing.

Types of bank credit

Bank credit comes in two different forms: secured and unsecured. Secured credit or debt is backed by some form of collateral, either in the form of cash or another tangible asset. In the case of a home loan, the property itself serves as collateral. Banks may also require certain borrowers to post cash collateral in order to obtain a secured credit card. Secured credit reduces the risk a bank takes on if the borrower defaults. Banks can seize the collateral, sell it, and use the proceeds to repay part or all of the loan. Because it is backed by collateral, this type of credit generally has a lower interest rate and more reasonable terms.

Unsecured credit, on the other hand, is not secured by collateral. These types of credit vehicles are riskier than secured debt because the risk of default is higher. Thus, banks generally charge higher interest rates to lenders for unsecured loans.

Examples of bank credit

The most common form of bank credit is the credit card. A credit card approval comes with a specific credit limit and an annual percentage rate (APR) based on the borrower’s credit history. The borrower is authorized to use the card to make purchases. They must pay either the full balance or the monthly minimum in order to continue borrowing until the credit limit is reached.

Banks also offer mortgages and car loans to borrowers. These are secured forms of credit that use the asset – the house or the vehicle – as collateral. Borrowers are required to make fixed payments at regular intervals, usually monthly, bi-weekly or monthly, using a fixed or variable interest rate.

An example of business credit is a business line of credit (LOC). These credit facilities are revolving loans granted to a company. They can be secured or unsecured and give businesses access to short-term capital. Credit limits are normally higher than those given to individuals due to business needs, creditworthiness and ability to repay. Commercial letters of credit are normally subject to annual reviews.