CHAPTER 4

CREDIT, ITS USES, CLASSIFICATIONS AND RISKS

Credit is defined as the power or ability to obtain money, goods and services at the present time in exchange for a
promise to pay with money upon demand or at a future determinable time. The reason for credit is the need or desire to
obtain economic goods. It is also depends on how the debtor convince the creditor to trust him.

FUNCTIONS OF CREDIT
1. Functions as a medium of exchange
2. Elevate the moral standards of the people
3. Enables businessman and corporation gather large amounts of capital
4. Allows wealth to be fully utilized
5. Helps in expansion and contraction of the money supply

CHARACTERISTICS OF CREDIT
*Credit as Bipartite contract – involves 2 parties the debtor and creditor.
*Credit as Pecuniary Contract – expressed in terms of money, when you buy or borrow money it is understood that
such obligation shall be paid in money.
*Credit as a Fiduciary Contract – debtor must always be able to merit the trust and confidence of the creditor.
*In Credit, risk is always involved –
*Credit always involves futurity – payment is always done at a future date.

SIGNIFICANCE OF CREDIT
Credit plays an important role in the distribution goods. It allows the production of goods which will increased the
employment of labor. The role of credit is to provide financial means for business who take advantages of market
opportunities in both domestic and foreign markets. Credit in the hands of consumer has a great impact on the quantity of
goods and services consumed. Today, many families depend on credit to be able to buy high-priced goods and many new
homes and automobiles are being financed by installment credit.

CREDIT AND BUSINESS CYCLE

A. Personal Credit – are those credits obtained for one’s use.
3 Types Personal Credit
1. Service Credit – obtained from doctors lawyers, dentist and other professionals. These professionals
usually bill us for their services, especially if we are acquainted with them.
2. Retail Credit – are goods obtained mostly on retail.
3 Categories of Retail Credit
a. Regular Charge Accounts- charged the goods you obtained on credit and usually pay within 15-20 days after
you are billed.
b. Revolving Charge – credit is not paid in full within his period but is divided into amounts, which are to be paid
in longer periods such as semi-monthly installments.
Example: Anson and Shoe mart credit cards or bank credit card
c. Installment Plan- resembles the revolving charge in that the debt is paid off over a certain period of time. Their
difference is that the creditor usually requires most of the time a down payment.
- It is paid in equal monthly payments ranges from 12 to 36 months
- Secured by chattel mortgage
- Only durable goods are sold on installment
- The title of the items sold on installment passes to the buyer only after he has made his last installment payment.
- Usually evidenced by written contracts.
Example: Cars, appliances, real estate and furniture
3. Personal Loan Credit – differs from other forms of consumer credit in that cash or money is given as credit
instead of goods and services.

Personal Loans- usually granted for the purchase of expensive consumer items. A good source of these kind
credit is the Social Security System (SSS), Government Service Insurance System (GSIS), building and loan associations,
home financing companies such as Pag-ibig plan.

Criteria for granting personal credit

Primary Factors
1. Wealth and accumulated resources
2. Wages, Salary and Regular remuneration
3. Operating expense of borrower
4. Sources of income
5. Size of family
6. Paying habits
7. Occupation
8. Length and employment permanence
“Truth in Lending Act”
- Is designed to protect consumers against unfair billing practices of people who extend credit to a purchaser of
goods on installment basis.

REQUIRED INFORMATION
1. The cash price of the property to be serviced or acquired.
2. The down payment, if any, or the trade in price.
3. The difference between the amounts under 1 and 2.
4. The charges, individually itemized, which are paid or to be paid in connection with the transaction and which are
not incidental to the extension of credit.
5. The total amount to be financed.
6. The finance charged expressed in terms of pesos.
7. The percentage that the finance charge bears to the total amount to be financed which is expressed as a simple
annual rate on the outstanding unpaid balance of the obligation.
*Any person who willfully violates the provision of the act – shall be fined by not less than PHP 5,000 or imprisoned
for not less than 6 months or not more than I year, or both.

B. Commercial or mercantile credit

- Are credits extended by one business to another business. Merchandise credits or trade credits are when
manufacturers extend a mercantile credit to a wholesaler, and wholesalers to retailers in the form pf goods.
- When Commercial credit transaction takes place?
-Commercial credit is generally an unsecured short-term type of credit. A commercial or mercantile credit as for its
purpose the facilitation of movements of goods through different stages of production and distribution. If producer of
materials may financially capable, he may grant credit to his customers and thus mercantile credit arises.
- Producer of raw materials is financially weak, the burden calls upon the purchaser or manufacturer
-Producer may finance the goods with his own capital or with borrowed money. These could be offered by the
manufacturer on credit to the distributors or wholesalers.

C. Bank Credit or Bank Loans – are credits granted by bank to businessman to finance their short term credit needs.
Example: Commercial banks

D. Export and import credit

-Export credits are obtained to finance the selling of goods outside the country. While import credits are also obtained
to finance the buying of goods from other countries
-Bank credit is introduced into international trade finance through the use of letters of credit and drafts.
-Letter of credit is a written commitment to pay, by a buyers’ or importer's bank called the issuing bank to the seller's or
exporter’s bank called the accepting bank or negotiating bank.

E. Investment credit – when a business prefers to acquire funds by entering a long term borrowing arrangement, it is
said to be using investment credit.
- Acquisition of fixed assets
* long term borrowing arrangement- one of the most common forms of financing used by business enterprise.
F. Agricultural Credit
1. Crop Loan- This loan is given to farmers for the purpose of financing the production of a particular crop like rice,
corn, peanuts, soybeans etc. Farmers cannot sell his crops unless he notifies his creditor.
2. Livestock Loan- This loan is obtained to finance the raising of pigs, chickens, ducks, goats, and other animals for
breeding purposes
3. Agricultural Time Loan- This loan is used to finance the development and improvement of a farmland. These are
short-term loans, used to finance the acquisition of farm equipment.
4. Commodity Loan- This loan is obtained to finance the selling and distribution of farm crops.

G. Industrial Credit – loans granted to industries to finance the acquisition of equipment’s and machineries, construction
of a plant or factory, and purchase of raw materials.
H. Real estate credit are loans to finance the purchase and improvement of real properties.
I. Government or Public credit- credits obtained from any of their gov’t institution or their instrumentalities.
-debtor maybe the national, provincial or local gov’t
J. Secured and Unsecured Credits
Secured credits are credits which are covered by properties of value called collaterals to guarantee loans, when
borrower fails to pay the creditor has the right to foreclose the mortgage and have such properties disposed of to satisfy
the former's obligation.
Unsecured credit is one where the borrower has merited the full trust and confidence of the creditor, also called
as character loan or clean loan.

K. Short-term, Medium-term, and Long term loans

Short-term loans are loans payable within a year. (current)
Example: commercial bank loans and retail credits
Medium-term loans are payable from 1 year to 5 year. Sometimes called intermediate term loan.
 Example: Car loans and installment plans on appliances
Long term loans are payable beyond five years and usually up to 15 to 20 years.
Example: Real estate loans and Investment loans

L. Direct loans, Discount Loans and Credit Lines

Direct Loans are loans whose interest payments are made at the time the loan matures, gets the entire amount and upon
maturity, he pays principal plus interest
Discount loans are those loans where interest payments are deducted at the time the loans are granted, borrower obtains
the proceeds of the loan, principal minus interest, upon maturity the debtor pays the entire amount loaned.
Credit Line is an agreement between the debtor and the creditor wherein the debtor is allowed to obtain funds from the
creditor up to a certain amount
THREE TYPES OF CREDIT LINES
1. Regular credit line- the debtor is allowed to draw funds from the creditor up to a certain amount agreed upon and the
funds drawn when paid can be borrowed again
2. Maximum loan commitment the borrower can obtain funds from the creditor up to a certain amount agreed upon.
Borrowed funds even when paid cannot be availed anymore
3. Overdraft line- credit line in which the bank allows its depositors to draw from the bank beyond their actual deposits.
These over drawings must be within an agreed amount.
In Regular credit line and maximum loan commitment, the bank charges interest the moment the borrower signs the
promissory note and transferred to the borrower's account

SOURCES OF CREDIT
Banks – are the most common sources of credit. Most of the commercial credits including industrial and agricultural
credits are obtained from the banks.
Classification
Commercial banks – specializes in giving commercial loans to businessmen.
Thrift banks – gives loan to individuals for their personal needs and to the industry for the enhancement of our
agriculture and our economy.
3 categories
Savings and mortgage bank – its purpose is to encourage thriftiness among people. It accumulates the savings of the
depositors.
Stock savings and loan association – engaged in the business of accumulating the savings of the people and using such
accumulated funds, together with its capital, for loans and investment in securities of productive enterprises or
securities of the government.
Private development bank – it aims to develop and expand the economy of the country pursuant to the socio-economic
program of the government.
Rural banks – organized to cater to the needs of farmers and small businessmen in the rural areas including the cottage
industries.

OTHER SOURCES OF CREDIT

1. Retail Stores – one of the biggest sources of personal credit.
2. Credit Unions are cooperative organizations that lend savings of their members to other members who are in need.
This is one of the cheapest sources of credit since borrowing members pays a very low interest on loans. Another
reason why the cooperative can afford to give low interest rate is because the overhead expenses of operating a
cooperative is very low, the officers and board of directors usually give their services for free and borrowing members
do not have to present collaterals, all they need are signatures of co-makers who are members
*Incase the borrowing member fails to pay, the co-signers assume the responsibility of paying debt
*At the end of each year, Organization gives patronage dividends to its members.
*Borrowing members are given dividends commensurate to the amount of loans they made with the organization.
FUNDS CAN BE CHANNELED THROUGH THE COOPERATIVES FOR THE DEVELOPMENT OF RURAL
AREAS
1. Individual Money Lenders are individuals who have excess funds and who usually lend such funds to others who
are in need. Lenders charge exorbitant interest for the use of his money because the risk is very great. (Borrowers do not
have collateral and loans are mainly based on their character. Sometimes referred to as loan sharks or usurers because
they practice usury, which is the charging of exorbitant interest.
2. Insurance companies are also sources of credits for insured individuals. They can borrow from their insurance
companies an amount equivalent to the cash surrender value of their policy
Cash surrender value refers to the value of a policy as it is surrendered after paying premiums for several years.
Sales Finance companies is one of the biggest sources of consumer's credit. They specialize in buying
installment contracts to sales finance companies at a discount.
PURCHASE OF THE INSTALLMENT CONTRACTS
1. Purchase without recourse basis is usually at a higher price, is often referred to as factoring (all future
installment contracts entered into by the company have already been contracted with a Sales Finance
Company.
2. Purchase with recourse basis where the risk involved is greater. Factoring is the purchasing of
installment contracts without recourse basis
CREDIT RISK
-refers to the possibility of non-payment of the obligation when it falls due. It may be minimized by a careful examination
of the C’s of credit.
1. Character – is a quality of credit risk, which makes the debtor pay or intend to pay when his debt is due.
2. Capacity – signifies the ability of a debtor to pay his obligation. It includes the ability of a company or
management to make good its commitment.
3. Capital – financial strength of business.
4. Collateral – properties of value pledged to secure a loan. They may be personal or real properties. It includes
financial and other resources such as bank deposits, inventories, receivables and other asset.
Chattel mortgages – loans secured by movable personal properties.
Real estate mortgages – loans secured by fixed assets.
Other collaterals that may be given are: Corporate securities, Signatures of co-markers and co-signers, Goods in
bonded warehouses represented by warehouse receipts.
5. Condition – refers to the environment in the customer’s industry, economically, legally and politically in relation
to growth. According to Chapin and Hassnet most business are subject to two types of movement:
a. The regular recurring seasonal activity
b. The regular oscillation of business as a whole

Hazards in the use of credit

Credit influences all units of our economy, the whole economy may suffer as a result of the improper use of
credit. Improper use of credit on non-productive goods may encourage consumption without a corresponding increase in
production and thus would result to inflation. It is important that borrowers should understand the benefits obtained from
credit and the consequences
Credit Information
It is important that the credit man should be able to gather information about his prospective debtors. Credit
information changes very often and, therefore, be sure that the information obtained is not obsolete. The accuracy of the
data should be also be considered. Credit information on companies that are posted in the stock market is more reliable.
The more correlation of information from different sources, the more reliable the information is.

Sources of Credit Information’s

1. Application form – it is the best source of data. It initiates the relationship between the debtor and creditor. It ranges
from single page information to as many as four to six pages. In installment credit, a new application is oftentimes
filed for every new purchase.
2. Personal interview – is the easiest source of credit information. It allows you to ask precisely want you want to know
and verify the information contained in his application form. It is necessary in opening new accounts and it is
important for the credit manager to make a preliminary investigation whenever possible before the contemplated
interview.
3. General Mercantile Agency – the principal service rendered, is to provide the credit information it has assembled
from all parts of its business field of operation. Its main purpose is to have updated and complete information
regarding the status of all business concerns. Credit information is collected through mailed inquiries from the
enterprises and from their creditors. It covers all lines of business.
4. Dun and Bradstreet – most frequently used general mercantile agency. It is also the oldest organization of its kind.
The reporting format indicates the highest recent credit extended by each reporting firm, how long the relationship has
existed, the amount of debt outstanding, terms of sale, manner of payment and past due balances. Its report is very
reliable and no further investigation is required.
5. Special Mercantile Agencies – are sometimes referred to as trade agencies. They are distinguished from general
mercantile agency in that their scope of coverage is limited to a single trade or limited to a number of allied trades.
Their major functions are to disseminate credit information through report, periodic supplement sheets and rating
books.
6. Personal investigation – is another form of gathering information for credit files. The company also makes use of
the services of independent correspondents located in remote areas. The system of personal investigation provides
interviewers that can investigate methodically and regularly.
7. Public and published record – these consist of all legal recordings such a deeds, mortgages, suits, judgments, and
current new items such as clippings from newspaper and trade journals.
8. Credit Bureaus – are associations of businessman providing information gathered from each other to other members
of the organization. In US, it is generally recognized among the most important sources of credit information and in
recent years become the most clearinghouses for information.
a. Retail credit bureaus – These may be mutual or cooperative associations. The ownership by local merchants is in
the form of local credit associations, then the association elects a board of director generally sets policies of
operation. The bureau may be operated for profit, operated by local chamber of commerce or charged fees for
their services.
b. Credit interchange bureau – is the exchanging of information among local credit bureaus. A system of
interchanged of ledger were developed, It operates on information accumulated from local bureau by requesting
participants to the interchange, to supply among themselves a complete list of their active accounts and reopened
account. They also furnish reports.
9. Bank Credit Department – one of the best sources of credit information because they are intimately involved in the
activities of their customers.
10. Information from Reference - reference indicated in the information sheets and obtained from the interview
could give light on the prospective customer’s credit worthiness.