Money and Credit
Credit and its terms
Explain when credit helps, when it harms, and what the terms of credit are.
What is credit? Credit (a loan) is an agreement in which the lender gives the borrower money, goods or services now, in return for a promise to pay later. Many everyday transactions involve credit in some form.
When credit helps: Salim's festival order. Two months before the festival, the shoe maker Salim gets an order for 3,000 pairs of shoes, due in a month. He must hire extra workers and buy raw materials, so he borrows from two sources:
- the leather supplier gives him leather now, to be paid for later;
- the big trader gives him a cash advance for 1000 pairs.
He delivers on time, makes a good profit and repays everything. Credit helped him meet his running costs (working capital) and earn more.
When credit traps: Swapna's crop. Swapna, a small farmer, grows groundnut on three acres. She borrows from a moneylender for farming costs. Midway, pests destroy her crop; expensive pesticides do not help. She cannot repay, and the debt grows. Next year she borrows again; the crop is normal, but the earnings cannot cover the old loan. She has to sell part of her land. This is a debt trap: credit leaves the borrower worse off, and recovery is very painful.
So, does credit help? It depends on the risk in the situation, and whether there is any support in case of loss. In villages, the main need for credit is crop production: seeds, fertilisers, pesticides, water, electricity, repairs. Farmers buy these three to four months before they sell the crop, so they borrow at the start of the season and repay after harvest. Repayment depends entirely on farm income, which is risky.
Terms of credit. Every loan comes with conditions:
- interest rate: what the borrower pays on top of the amount borrowed (the principal);
- collateral: an asset the borrower owns (land, a building, a vehicle, livestock, bank deposits) kept as a guarantee. If the loan is not repaid, the lender can sell it to get the money back;
- documents the lender asks for;
- mode of repayment: how, and how often, it is paid back.
These terms vary a lot, depending on the lender and the borrower.
Megha's house loan. Megha borrows Rs 5 lakhs from a bank to buy a house. The interest rate is 12 per cent a year, to be repaid over 10 years in monthly instalments. She had to show her employment and salary records. The bank keeps the papers of her new house as collateral, and returns them only when she has repaid the whole loan with interest.
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