Difference between loan and credit

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The words loan and credit in the colloquial language and even in more technical fields such as the legal one are practically equivalent.

For example, the first meaning in the Dictionary of the Royal Spanish Academy of “credit” is “amount of money or other means of payment that a person or entity, especially banking, lends to another under certain conditions of return.” Another example: a transcendental law for mortgage loan consumers, that is, for almost all of us during some years of our lives, is called the “Real Estate Credit Contract Law.”

Once we can rest assured with the certainty that we can use both terms interchangeably, it is convenient to know the differences between loans and credits when we refer to them as financial products.

What is a loan?

A loan is defined as a contract under which a financial entity (“Lender”) delivers to its client (“borrower”) a certain amount of money (“principal”, “principal”) in exchange for its return in a given term and according to agreed conditions, entailing the payment of the corresponding interests.

Normally the form of payment of the loans is monthly, paying the first receipt just the month following the signature. Receipts are always the same, including both interest (which is technically the price of money) and a part of the capital borrowed. This form of payment is called the “French amortization system”.

It is interesting to keep in mind that each receipt interest is paid only for the outstanding capital at each time. For this reason, less and less interest is paid on each monthly receipt, because less capital is owed every month. The difference between the total amount of the installment and the corresponding interest is the part that is destined to pay the capital of the loan.

If we assume a loan of 10,000 dollars for a 12-month term and an interest rate of 6.0%, the resulting installment will be $ 860.66. The amount of the fee can be calculated, for example, in the simulators available on the websites of the Bank.

If you add the interest of all fees the total amount will be $ 327.96. That is, it will not be the $ 600 (6% on 10,000 dollars) that some readers would expect. This is precise because of the comments that interest is only charged for the capital borrowed at any time.

Not all loans conform to the definition expressed above

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In some cases, loans may be available gradually. On other occasions, capital does not begin to be returned from the beginning but after what is called a period of lack.

For the first case, let’s think of a private individual who is going to build a house. Or in large investment projects such as a toll highway. The logical thing in these cases is to have the financing available as the investment progresses. The borrower, on the one hand, avoids paying interest for the money he has not used. On the part of the bank, it is guaranteed that your funds will be used exclusively for the intended purpose.

In the second case, we are facing loan modality with a period of lack. This means that during an initial period (six months or one or two years) the borrower only pays interest and not capital. This modality is justified by new investments that require a shooting period.

It is expected during the initial phase of investment and start-up and when it begins to generate recurring income, the principal of the loan begins to be paid. It should be borne in mind that there are no periods of lack of interest, they are only granted for capital.

What is credit?

What is a credit?

While loans are used by both individuals and companies, credit accounts are used by companies, professionals, and freelancers.

With a specific meaning, a credit is a contract under which the financial institution makes available to the client (called “credited”) a certain maximum amount of money (“credit limit”) for a specific period (usually one year), in exchange for the payment of interest (for the amounts arranged) and for a series of commissions (normally opening and availability).

From a functional point of view, loans are financial instruments that are used by companies to finance their working capital needs: financing of purchases and stocks, financing of accounts receivable from customers, etc.

Credit accounts, therefore, are very common products for companies. For banks, from a risk point of view, granting credit accounts to their clients allows them to know their businesses quite well. Operational operation is identical to that of a checking account. Therefore, the daily movements of these accounts are a reflection of the daily activity of the company: collections, payments, direct debits, customers, suppliers, etc.

As with loans, the bank charges interest exclusively for the capital arranged. In the case of loans, interest is calculated day by day according to the amounts provided. In addition to interest, banks charge a commission for the average undrawn balance (“availability fee”).

Banks seek to meet the financing needs of individuals and companies. Loans and credits are two basic products for this. Very different from each other in the details, although in the colloquial and even professional language both words are used for the same concept.

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