What is the cost of credit?

The cost of credit is an extra amount that the borrower has to pay besides the loan amount. These credit charges may vary from loan to loan. The cost of credit includes interest charges, maintenance charges, and arrangement charges. Some of the costs are mandatorily collected by the lender based on the loan amount and tenure of the loan. The cost of credit is also called finance charges of the credit.

Types of cost of credit

The following are some of the costs of credits:

Interest

Interest is the amount charged by the lender from the borrower in addition to the principal amount. Interest is payable to the lender every month or according to any other term agreed upon by the parties. Interest rates may vary from lender to lender and credit to credit. Interest cost is the finance charge that the borrower should pay on the borrowed money during the tenure of borrowing. Interest rates are divided into fixed interest rates and variable interest rates.

Fixed interest rate

A fixed interest rate means a fixed percentage of interest collected on the loan amount. In fixed-rate borrowings, interest rates should be fixed for the entire tenure of the loan. The rate does not vary during the loan term.

Variable interest rate

A variable interest rate is an interest rate that may vary during the period of credit based on the market rate or federal rate. The variable interest rate may increase or decrease based on the variations in the underlying index. The variable interest rate is known as the floating rate. Floating rates are widely used in swaps and credit cards.

Initiation fee

This fee amount should be paid at the time of initiation of the credits. The initiation fee is calculated based on the loan amount, type of loan, interest rate, and duration of the loan. Borrowers can pay the amount at the time of loan arrangement or this fee can be added to the loan outstanding amount.

Service fee

A service fee is a finance charge which is charged from the borrowers as a percentage of borrowings. A service fee is levied on the loans from the date of borrowing to the closure of the loan. The service fee is otherwise called administration cost. This fee is paid for keeping credit records, collecting monthly payments, and updating outstanding balance loan amounts.

What is tenure in credit?

Tenure is a period of credit that starts with the disbursement of credit and ends at the time of closing of the credit. Tenure for credits may vary based on the nature of the credit and the lender. The borrower is liable to settle the principal and interest of the credit during the tenure of the credit. Longer tenure periods involve smaller monthly payments whereas shorter tenures involve longer monthly payments.

The formula for cost of credit

The cost of credit can be computed using the following formula:

$\mathrm{Cost} \mathrm{of} \mathrm{Credit} =\mathrm{Loan} \mathrm{Amount}\times \mathrm{Annual} \mathrm{Interest} \mathrm{Rate}\times \mathrm{Time} \mathrm{of} \mathrm{Loan}$

To calculate the monthly cost of credit, the annual cost of credit should be divided by 12 months. Simple interest or cost of credit can be calculated using this formula. For example, the loan amount is $3,000, the interest rate is 10% per annum, and the tenure of the loan is one year. The monthly interest cost will be $25.

$$\begin{gathered} \mathrm{Monthly} \mathrm{Cost} \mathrm{of} \mathrm{Credit} =\mathrm{Loan} \mathrm{Amount}\times \mathrm{Interest} \mathrm{Rate}\times \frac{\mathrm{Number} \mathrm{of} \mathrm{Months}}{12} \\ \mathrm{Monthly} \mathrm{Cost} \mathrm{of} \mathrm{Credit} =\$3,000\times 10\%\times \frac{1}{12}=\$25 \end{gathered}$$

Credit types

The following are the types of credits:

Credit card

Credit cards are one of the borrowing methods which helps to acquire short-term credit. Credit cards help borrowers to manage their credit scores. Credit card cost is determined based on the type of credit card and usage of the credit card. In credit card payments, credit card issuers fix a percentage of interest and monthly credit limit for purchases and other uses. This limit is determined based on the earnings, credit score, and credit history of the borrower. At the end of each month, the credit card issuer sends a monthly report to the cardholders. In this monthly statement, they provide the details of the purchases or payments made, amount due, due date, interest rate, and the credit card balance. The amount due is the money that the cardholder is liable to pay before the due date.

Trade credit

Trade credit means entering into an agreement with a creditor to buy goods or services on credit. In simple terms, trade credit means purchasing goods or services without making immediate cash flows. This trade credit is helpful for small businesses. When the customer asks for trade credit terms and the creditor doesn’t agree to trade credit with the customer, it will affect the customer relationships. Business owners should be careful while determining trade credit periods as it affects working capital and liquidity.

Limitations of credits

The following are the limitations of credit:

Higher cost of credit

Lenders charge high-interest rates and various finance charges from borrowers for the money they lend. Some of the costs of credits are interest costs, maintenance fees, service fees, and loan initiation fees. These charges are collected at the time of borrowing and over the period of borrowing along with the loan amount. The interest amount should be paid along with the principal on or before the due date. Thus, the credit involves higher finance charges.

Motivate lending

Even though the cost of credit is higher, people and business organizations are still looking for borrowings for their business and personal needs. Lenders are willing to lend money at a high rate of interest and based on the paying capacity of the borrowers. A higher rate of interest puts an additional burden on the borrowers to meet the hefty interest payments. Therefore, higher interest rates motivate lenders to lend more funds in return for a higher earning.

Deficient credit record

When the borrowers default on debt repayments, it will affect the credit records of the borrower. The borrower must pay his/her debts on or before the due period. Due to financial distress, if the borrower defaulted in repayments it will adversely affect the credit score of the borrower.

Context and Applications

This topic is significant in general studies, professional exams, and also for both undergraduate courses and postgraduate courses and competitive exams especially for

• Bachelors of Commerce
• Master of Commerce
• Bachelors of Business Administration in Finance
• Master of Business Administration in Finance

Practical Problems

Question 1: What is the cost of credit?

   a) Additional amount besides the borrowing money

   b) Certain amount received by the borrower

   c) All of the above

Answer: Option (a) is correct.

Explanation: The cost of credit is an extra amount that the borrower has to pay besides the debt amount. These charges may vary from loan to loan. Interest payment, service fee, and initiation fee are some of the credit costs.

Question 2: What is called the administration cost of credits?

   a) Interest amount

   b) Service fee

   c) Initiation cost

Answer: Option (b) is correct.

Explanation: Service fee is otherwise called administration cost of credits. A service fee is levied on the loans from the date of borrowing until the loan tenure. Service fee is collected for keeping the loan records, collecting payments, and updating loan balances.

Question 3: What are the types of interest rates?

   a) Fixed rate

   b) Floating rate

c) All of the above

Answer: Option (c) is correct.

Explanation: Interest rates are classified into a fixed rate and a floating rate. In fixed interest rates, interest is charged based on a fixed percentage over the period of the loan. In variable interest rate, the interest rate is variable based on the market rate and federal rate.

Question 4: The loan amount is $12,000, the interest rate is 15% per annum. Calculate monthly interest payment.

   a) $1,200

   b) $120

   c) $150

Answer: Option (c) is correct.

Explanation: Loan amount is multiplied by interest rate per annum for calculating annual interest payment. To calculate monthly interest payment, the annual interest payment is divided by 12 months. The interest payment is $150 per month.

$\mathrm{Monthly} \mathrm{Interest} \mathrm{Payment}=\$12,000\times 15\%\times \frac{1}{12}=\$150$

Question 5: What are the limitations of credits?

   a) Convenience

   b) Deficient credit record

   c) All of the above

Answer: Option (b) is correct.

Explanation: Deficient credit record is one of the limitations of credit. Higher indebtedness requires higher repayments on a monthly basis or any other agreed terms. Due to financial distress, if the borrower defaults in repayments it will negatively affect the credit record of the borrowers.