Introduction to Credit: Types of Credits

Summary

This chapter delves into various types of credit, including revolving credit, installment loans, and open credit, exploring their features, advantages, and drawbacks. It explains key concepts like principal, interest (simple vs. compound), secured vs. unsecured loans, and fixed vs. variable rate loans. The chapter also compares amortizing and non-amortizing loans, emphasizing their differences in repayment structures. By the end, readers will gain a comprehensive understanding of how to choose the most suitable credit product based on their needs, as well as the benefits and risks for both borrowers and lenders.

Takeaways

• 😀 Revolving credit allows flexibility with a capped limit but no fixed repayment schedule (e.g., credit cards).
• 😀 Installment loans have a fixed repayment schedule, often for long-term purchases like mortgages, car loans, or student loans.
• 😀 Open credit requires full repayment at the end of each period, such as utility bills or phone bills.
• 😀 Loan payments consist of principal (the amount borrowed) and interest (the cost of borrowing).
• 😀 Regular interest is paid during the loan term, while accrued interest accumulates and is paid later.
• 😀 Secured loans are backed by collateral, such as a mortgage backed by a house, typically resulting in lower interest rates.
• 😀 Unsecured loans don’t require collateral but often have higher interest rates due to the increased risk for lenders.
• 😀 Amortizing loans require payments toward the principal over time, reducing the balance gradually, while non-amortizing loans only require interest payments until the end.
• 😀 Fixed rate loans have a stable interest rate over the life of the loan, making it easier to plan, but are less flexible if interest rates fall.
• 😀 Variable rate loans have interest rates that change over time based on reference rates, benefiting borrowers if rates drop but increasing costs if rates rise.
• 😀 Combining loan features, such as secured, amortizing, and fixed rate, can create customized lending products, like machinery financing loans.

Q & A

What are the three main types of credit mentioned in the script?

The three main types of credit are revolving credit, installment loans, and open credit.

How does revolving credit work?

Revolving credit is a line of credit with a capped limit. You can borrow up to the limit and pay it back in varying amounts, with no fixed repayment schedule, although minimum payments may be required.

What is the difference between amortizing and non-amortizing loans?

Amortizing loans have fixed or equal payments that reduce the principal over time, whereas non-amortizing loans require the entire principal to be repaid at the end of the loan term, with only interest payments made along the way.

What is the role of interest in a loan?

Interest is the cost of borrowing money, paid by the borrower to compensate the lender for the risk of lending. It is calculated as a percentage of the outstanding loan principal.

What are the two types of interest explained in the script?

The two types of interest are regular interest, which is paid in cash during the loan period, and accrued interest, which is calculated but paid later.

How does simple interest differ from compound interest?

Simple interest is calculated only on the original loan principal, while compound interest is calculated on the principal plus any accumulated interest, causing the interest to grow over time.

What is the difference between secured and unsecured loans?

Secured loans are backed by collateral, such as a house for a mortgage, reducing the lender's risk. Unsecured loans do not require collateral and rely on the borrower's creditworthiness.

What are the advantages of secured loans for borrowers and lenders?

For borrowers, secured loans usually have lower interest rates due to the reduced risk for lenders. For lenders, secured loans provide protection through collateral in case the borrower defaults.

Why might a borrower choose a non-amortizing loan over an amortizing loan?

A borrower might choose a non-amortizing loan because it has smaller payments since no principal is repaid until the end. This can help conserve cash flow, although the total interest cost over the life of the loan is higher.

What is the key benefit of a fixed rate loan compared to a variable rate loan?

The key benefit of a fixed rate loan is that the interest rate remains constant over the loan term, making it easier for the borrower to plan payments. A variable rate loan, however, can fluctuate based on market interest rates, potentially saving the borrower money if rates fall.

How do lenders combine features of different loan types to create customized products?

Lenders combine features such as security (collateral), amortizing terms, fixed or variable interest rates, and whether the loan is secured or unsecured to tailor lending products to the specific needs of borrowers.

What factors would influence the type of loan a borrower should choose in a given scenario?

Factors include the borrower's creditworthiness, the purpose of the loan (e.g., purchasing a house or business expansion), whether they prefer predictable payments or lower interest costs, and their expectations about future interest rates.