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Understanding Credit

     
    Credit covers a loan or any other advance or accommodation given by an individual or financial institution. By giving credit the lender is displaying trust that the person will pay for the facilities given or for the money borrowed.
     
     
    A credit rating assesses the credit worthiness of an individual, corporation, or even a country. Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit.
    A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high interest rates
     
    Credit rating is an opinion on the creditworthiness of a person. When a lending institution is considering a loan application by a borrower, there are some key questions or some essential information that will be used to assess his/her creditworthiness. The following are some questions that are generally asked: -
     
    ·        Can you pay?
    ·        Where do you work? 
    ·        How long have you been employed?   
    ·        How stable is your job? 
    ·        Does your income include variables such as overtime or bonus? 
    ·        How much do you owe and how much is the repayment obligation? 
    ·        Do you have lots of debts? 
    ·        Do you make payment on time?
    ·        Do you have a lot of credit enquiries? 
    ·        Do you have equity to protect? 
    ·        Are you highly indebted?
    ·        Do you have cash reserves? 
     
    If the lender is satisfied with the answers given by a borrower to the questions stated above, a credit relationship might be established.
     
    How can You Establish your Creditworthiness?
     
    Creditworthiness can be achieved by building your equity. This can be achieved by: -
     
    ·        Developing positive saving habits by putting aside a specific sum of money in an account at a financial institution monthly, or from time to time. It is advisable that at least 10 per cent of one’s income should be saved. 
     
    ·        Accumulate cash in Whole Life Insurance or other forms of Annuity Insurance as an investment or as saving or equity. 
     
    ·        Investing in stocks and bonds that can be easily converted to cash. These instruments contribute to diversifying your assets. Purchasing shares and stocks in a company can also result in positive returns. However, shares are more risky than purchasing bonds, but the returns could be higher. 
     
    ·        Acquiring or purchasing of land. Try to acquire land before approaching a lender. The ownership of land engenders a favorable response by lenders. Land is also an asset that can appreciate quickly.
     
    There are other forms of investments by which one can build equity including: -
     
    ·        Fixed Deposits;
    ·        Treasury Bills;
    ·        Debentures;
    ·        Corporate Bonds;
    ·        Government Bonds;
    ·        Savings Plan tied to future investment;
    ·        Retirement Plans
     
    The ability of an individual to generate savings is a measure of discipline. It is a commitment and it is a sign of thrift. It means that you have managed your resources very well.
     
     
    Consumer Credit Risk is the risk of loss due to a customer's non re-payment (default) on a consumer credit product, such as a mortgage, unsecured personal loan, credit card, overdraft etc.
     
    Consumer Credit Risk Management
     
    Most companies involved in lending to consumers have departments dedicated to the measurement, prediction and control of losses due to credit risk. This is referred to consumer/retail credit risk management.
     
    Consumer Credit Risk
     
    Most lenders employ their own models (Credit Scorecards) to rank potential and existing customers according to risk, and then apply appropriate strategies. With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa. With revolving products such as credit cards and overdrafts, risk is controlled through careful setting of credit limits. Some products also require security, most commonly in the form of property.
     
    Faced by lenders to business
     
    Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged. But interest rates are not the only method to compensate for risk. Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:|

    ·        limit the borrower's ability to weaken his balance sheet voluntarily e.g., by buying backshares, or paying dividends, or borrowing further.
     

    ·        allow for monitoring the debt by requiring audits, and monthly reports
    ·        allow the lender to decide when he can recall the loan based on specific events or when financial ratios like debt/equity, or interest coverage deteriorate.
     
    A recent innovation to protect lenders and bond holders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow companies to buy protection against defaults from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes, and in return it agrees to buy the debt should a credit event ("default") occur.
     
    Faced by business
     
    Companies carry credit risk when, for example, they do not demand up-front cash payment for products or services. By delivering the product or service first and billing the customer later - if it's a business customer the terms may be quoted as net 30 - the company is carrying a risk between the delivery and payment.
    Significant resources and sophisticated programs are used to analyze and manage risk. Some companies run a credit risk department whose job is to assess the financial health of their customers, and extend credit (or not) accordingly. They may use in house programs to advise on avoiding, reducing and transferring risk. They also use third party provided intelligence.
     
    For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by tightening payment terms to "net 15", or by actually selling fewer products on credit to the retailer, or even cutting off credit entirely, and demanding payment in advance. Such strategies impact on sales volume but reduce exposure to credit risk and subsequent payment defaults.
     
    Credit risk is not really manageable for very small companies (i.e., those with only one or two customers). This makes these companies very vulnerable to defaults, or even payment delays by their customers.
    The use of a collection agency is not really a tool to manage credit risk; rather, it is an extreme measure closer to a write down in that the creditor expects a below-agreed return after the collection agency takes its share (if it is able to get anything at all).
     
    Faced by individuals

    Consumers may also face credit risk in a direct form as depositors at banks or as investors/lenders. They may also face credit risk when entering into standard commercial transactions by providing a deposit to their counterparty, e.g. for a large purchase or a real estate rental. Employees of any firm also depend on the firm's ability to pay wages, and are exposed to the credit risk of their employer.

    In some cases, governments recognize that an individual's capacity to evaluate credit risk may be limited, and the risk may reduce economic efficiency; governments may enact various legal measures or mechanisms with the intention of protecting consumers against some of these risks. Bank deposits, notably, are insured in many countries (to some maximum amount) for individuals, effectively limiting their credit risk to banks and increasing their willingness to use the banking system