Credit
Definitions and Basics
Credit, from EconEdLink.
Credit is the ability of an individual or organization to obtain goods or services before payment, based on an agreement to pay later.
Credit for Beginners, a lesson plan at EconEdLink.
This lesson focuses on teaching students the basics about credit. It explains why credit is important, how to keep good credit and several of the terms that are associated with credit.
Bonds, Borrowing, and Lending, on Econlib.
A bond is a promise to pay. It is a promise to pay something in the future in exchange for receiving something today.
Promises—that is, bonds—can be bought and sold. The buyer of a bond is a lender. The seller of a bond is a borrower. The bond buyers pay now in exchange for promises of future repayment—that is, they are lenders. The bond sellers receive money now and in exchange for their promises of future repayment—that is, they are borrowers.
Bonds can be traded privately between individuals or in organized markets, called bond markets or credit markets.
You may not realize it, but you buy and sell bonds all the time! Every time you lend someone a few dollars for lunch or borrow your friend’s car in exchange for filling her tank, in economic terms you are buying and selling bonds. Simply remembering that bond buyers are lenders, bond sellers are borrowers, and that they are trading not pieces of paper but promises, can unlock the door to understanding both the vocabulary and the economics of a wide range of economic behavior, from private loans to interest rates to government budget deficits. It’s much easier to understand borrowing and lending than abstract vocabulary like “the bond market”—even though they are the same thing—because we can by think about our own familiar experiences with borrowing and lending….
When you use your credit cards or buy on installment, you are a borrower. In each case, someone—a bank or business owner—lends you the money by directly paying for the goods up front on your behalf. The lender later sends you a bill, at which time you are responsible to pay the principal and any accumulated interest to the lender. In economic terms, every time you use your credit card, you sell a bond—your promise to repay the credit card company in the future.
When you deposit money in a bank, you are a lender! In economic terms, you buy the bank’s bond— its commitment to repay you when you decide to use the money. The bank acts as an intermediary (a go-between) and pairs you with a borrower….
Here’s another example. When you buy a Treasury Bill, you are lending to the government. The government sells its promises to pay in organized markets each week….
Classroom activity. To illustrate these concepts in the classroom, I’ve often held a bond auction in class!
Interest, from the Concise Encyclopedia of Economics
Interest rates quoted by lenders usually include much more than “pure” interest. To persuade a lender to surrender current control of resources, the borrower will have to pay, in addition to interest, an amount that compensates the lender for any costs incurred in arranging the transaction, usually including some kind of insurance premium against the risk of default by the borrower. Someone without an established credit rating who applies for an unsecured loan will typically be required to pay “interest” at an annual rate that is several times the prevailing rate of pure interest….
FICO scores and credit bureaus, at Khan Academy.
David Henderson, In Praise of Debt, at Econlib, June 2016.
If I were to put it in Polonius’s terms, I would say it this way: “Both a borrower and a lender be.” That is, at some points in your life, it makes sense to borrow, and at other points, it makes sense to lend. In this article, I focus on borrowing. What follows is my case for debt.
In the News and Examples
The Costs of Credit, a lesson plan at EconEdLink.
“Will that be cash, check, debit, or credit?” This lesson plan explores the difference between these. What is the difference? Is using credit the same as paying with cash? Or by check? Or by debit card? Some young people believe that using credit is the same as paying with cash. In fact, some young people believe that all you need to make purchases is a credit card. It seems as if a credit card can pay for anything-and everything. But how you pay for things does make a difference. In this lesson, you will learn how using credit differs from paying in cash, by check, or by debit card. You will learn why credit has costs, and what the influences are that affect the cost of credit.
Payday Loans, at Khan Academy.
Munger on Microfinance, Savings, and Poverty, EconTalk podcast, April 2011.
Mike Munger of Duke University talks with EconTalk host Russ Roberts about microfinance. Munger argues that cultural forces make it difficult for some families to save, and the main value of microfinance is to allow a higher level of savings. Families are willing to save via microfinance even though returns can be negative. Munger argues that this counterintuitive result is possible when other means of savings are unavailable. Munger also discusses microfinance that is used for entrepreneurship and the potential role for microfinance in development.
A Little History: Primary Sources and References
Deposit Insurance, from the Concise Encyclopedia of Economics
Federal deposit insurance became law for commercial banks in 1933 as part of the Glass-Steagall Act, and for S&Ls in 1934. Although a number of state governments had provided deposit insurance before 1933, most state programs had failed and all had been disbanded by then. The federal program was enacted only after long debate.
The Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC) were both established in 1934….
Savings and Loan Crisis, by Bert Ely from the Concise Encyclopedia of Economics
Years later, the extraordinary cost of the 1980s S&L crisis still astounds many taxpayers, depositors, and policymakers. The cost of bailing out the Federal Savings and Loan Insurance Corporation (FSLIC), which insured the deposits in failed S&Ls, may eventually exceed $160 billion. At the end of 2004, the direct cost of the S&L crisis to taxpayers was $124 billion, according to financial statements published by the Federal Deposit Insurance Corporation (FDIC), the successor to the FSLIC. Additionally, healthy S&Ls as well as commercial banks have been taxed approximately another $30 billion to pay for S&L cleanup costs. Finally, the federal courts are still resolving the so-called goodwill cases stemming from regulatorily inspired mergers of failing S&Ls into healthy S&Ls in the early 1980s (discussed below). Resolving these cases will probably cost taxpayers another $5–$10 billion.
Advanced Resources
More lessons from EconEdLink on credit.
Lesson titles include: Developing Good Credit Habits, Building Good Credit Scores, and Establishing Credit.
Zywicki on Debt and Bankruptcy, EconTalk podcast, March 2009.
Todd Zywicki, of George Mason University Law School, talks with EconTalk host Russ Roberts about the evolving world of consumer debt and how institutions and public policy have influenced consumer access to debt and credit. Zywicki defends consumer credit as a crucial benefit to consumers and that innovation has made credit cheaper and more effective. He also talks about how misleading it can be to look at only one piece or another of credit picture.
Kling on Credit Default Swaps, Counterparty Risk, and the Political Economy of Financial Regulation. EconTalk podcast, November 2008.
Arnold Kling of EconLog talks with EconTalk host Russ Roberts about the role of credit default swaps and counterparty risks in the current financial mess. The conversation opens with the logistics of credit default swaps and counterparty risks and moves on to their role in the financial collapse. The conversation closes with a discussion of the political economy of pending financial regulation.