NATURE OF CREDIT

Credit is the ability to obtain a thing of value in exchange for a promise to pay definite sum of money, on
demand or future determinable time. This creates obligations and rights to both debtor and creditor.
There is the obligation of the debtor to pay his debt and the right of the creditor to collect payment. From
the definition, the following elements are present:

1.It is the ability to obtain a thing of value. Thing of value may mean cash form of credit or merchandise
form of credit. Debtor can apply for cash credit from several sources like banks, private individuals or other
financial intermediaries. Merchandise form of credit is non-cash form, where sources are retail outlets
and the like.

2. A promise to pay. The debtor makes a promise to pay the creditor. A promise to pay, to be valid should
be in writing, acknowledged by both the debtor and the creditor. The promise should specify the principal
amount, interest and the maturity to date.

3.Definite sum of money. Credit involves exact amount of money loaned, or money value for non-cash
form of credit. The contract must identify the principal value of loan and the corresponding interest for the
credit period.

4. Payable on demand or future time. A promise by the debtor for the settlement of obligation may
involve a future date as loan maturity, or anytime the creditor demands payment.

Sources and Bases of Credit

Important Sources of Credit

Individual Money Lenders

individual money lender who may lend his surplus to those in need so that it will bring some income to him
-no collateral is required on the part of borrowers to secure the loan of whatever sum money
-the money lender may be constrained to collect a very high rate of interest over and above the legal one
in order to protect his personal interest and thus become what is known as "loan- shark"

The unlicensed money-lender, who is often referred to as a "loan-shark", does a thriving business in the
grant of loans at very exorbitant rates of interest.

Usurious money lenders are called as "Loan-sharks simply because once they get hold of a borrower,
they rarely let him go. These lenders are not interested in the repayment of the loan but in keeping the
borrower continually in debt. Most of them refuse to accept any payment except the full amount, and
all of them charge exorbitant rates of interest. They find their customers among those who are ignorant
of, or unable to borrow from reputable sources.

Retail Store

Easily the biggest source of merchandise credit in the Philippines is the retail store, more
particularly known as the "sari-sari" store. This becomes evident when one takes into account
the number of such sari-sari stores in every barangay of our communities. These stores cater to
the everyday needs of the consumers, which explain their large numbers. Such stores are run by
Filipinos and aliens alike, although after May 15, 1954, in accordance with the provisions of the
Retail Trade Nationalization Law, no alien is permitted to engage in this type of business.

Pawnshops

The present-day pawnshops owe their origin from the Montes Pietatis which were established by
Franciscans (Friar Minor as they were invariably called then) in Italy. The terms mons referred to any
form of capital accumulation and pietatis from the Latin "pietas" meaning pious. As such, montes
pietatis consisted of charitable funds from which loans came from, which were exempted from interest,
but secured by pledges. Such loans were granted to the poor.

According to Uen Sheng Yang, a Harvard professor of Chinese history, pawnshop is the "oldest credit
institution in China" whose origin could be traced to as early as the middle of the Six dynasties (about
the 5 century) when Buddhist monasteries practiced pawn broking with large amount of donated wealth
in their treasuries.

In the Philippines, pawn broking is also one of the oldest credit institutions and is believed to have been
introduced by the Spanish friars when we were under the Crown of Spain. It may be interesting to point
out, in this connection, that the oldest saving bank, the Monte de Piedad, was granted the privilege of
lending money against pledge of jewelry.

Commercial Banks

Commercial banks are engaged in the grant of loans not only to businessmen, but also to individuals for
personal purposes Generally speaking, in the case of personal loans, borrowers are required to furnish
the bank with the written guarantee of two or more responsible persons that the contract will be
faithfully performed. These guarantors of the credit of the borrower are called "co-makers”. Legally,
they can be held for principal and interest due, in the event that the borrower for whom they acted as
guarantors fails to discharge his obligations incurred with the bank. As a common banking practice, a
charge of 6 to 12% of the entire loan is deducted in advance to represent the interest.
There is also what is known as "character loan" wherein no guarantors nor pledges are required Such
loans, usually consisting of small sums of money, are based upon the character of the borrower. Hence,
the descriptive term "character loan". This kind of loan is being granted by the PNB.

In the case of loans granted by the bank for commercial purposes, the borrower may be given
the amount of applied for and approved in terms of cold cash. In other cases, the bank furnishes
the borrower not with money, but instead allows him to deposit against which the said
borrower can draw checks. These deposits are created as part of the lending operations of the
bank.

Commercial Paper House

The commercial paper house is a financial institution that brings together the buyer and seller of short-
term commercial paper, that is, the lending institution and the borrowing business enterprise. The
commercial paper includes notes, bankers acceptances, trade acceptances, and foreign exchange bills. A
commercial paper house also buys issues outright at a discount and resell the notes at a slightly higher
price to investors. Under such an instance, the commercial paper house assumes the risk of loss that
may result from sudden change in money rates in the market, or even, of buying an issue that cannot be
sold because investors shy away from it. Most of the paper bought by a commercial paper house takes
the form of unsecured single- name promissory note.

•Savings Bank

Since savings banks accumulate the small savings of depositors, such accumulated funds are in turn
invested in bonds or in loans secured by bonds, real estate mortgages, and other forms of security.

In its broadest meaning, the term savings banks include mortgage banks as well as savings and loan
associations. Savings and loan associations are established on the principle of cooperation.

•Rural Banks

In the rural areas of the Philippines, rural banks provide the chief source of credit especially for those
engaged in agriculture who need these facilities badly. Such type of banks were unknown in this country
prior to the enactment of RA 720, known as the Rural Banks Act.

The growth and development of these banks attest to the pressing need of the people in the rural areas
for loanable funds. Undoubtedly, the existence of rural banks in the towns and communities has greatly
minimized the existence of usurious practices of some money lenders, which has victimized our poor
people who cannot avail themselves of the credit facilities which may be offered by commercial and
savings banks because of certain requirements imposed by them.
•Development Banks

Like those of rural banks, development banks from an important part of our banking system extending
the necessary fund for purposes of hastening development. They have been largely responsible for the
birth and development of certain industries that are now quite common an the Philippine scene.

•Investment Banks

Investment banks, at times termed as investment houses, bridge the gap between those who have idle
funds not knowing where to invest them and those in dire need of such funds.

As sources of credits, they help raise the needed funds that are not easily procurable elsewhere for use
because of the sizeable amounts involved and the length of time for their use.

The funds provided by investment banks are important not only to entrepreneurs, but to government as
well, which requires huge expenditures to support the various economic projects that are part of its
program.

•Savings and Loan Associations

Another sources of credit are savings and loan association which may be described as "that
corporation engaged in the business of accumulating savings of their members as stockholders,
and using such accumulations, together with their capital in the case of stock corporations, for
loans and/or investments in the securities of productive enterprises or in securities of the
Government, or any of its political subdivisions, instrumentalities or corporations.

•Finance Companies

As an industry, it shares with government the universal goal of achieving a strong and healthy financial
system. Given an conducive regulatory environment, finance companies can effectively mobilize
resources needed for productive investments. They have developed into a major source of funds for
consumer, sales and commercial financing.

Finance companies may be divided into three categories:

1. The installment sales finance companies-discount consumer installment notes arising
through the sale of merchandise
2. The consumer finance companies-engaged in lending cash directly to the consumer
3. Commercial finance companies-which through various types of loans serve business and industry
Credit Unions

Credit unions are corporate organizations which lend savings of members to some of the members of
the group. However, in order that credit unions can be successfully operated, they should consist of
closely knit, cohesive, natural groups of employees with low labor turnover.

Advantages

1. Low cost of operation, ordinarily, the office space for such purpose is donated by the management
2. Losses are very small in view of the fact that there exists an intimate relationship among all
the members of the credit union
3 Rates charged for interest by credit unions are very much lower than those charged on similar loans
by commercial lenders
4. Member-borrowers also become entitled to the receipt of patronage dividends when the
same is distributed by the credit union

Insurance Companies

The business of insurance companies is to enter into insurance contracts with those who wish to
provide for such contingencies as death or fire. They receive premiums and pay out money on the
occurrence of the particular contingencies covered by the contracts. Insurance companies cannot,
therefore, be regarded as financial institutions per se, like banks. They are, however, important
participants in the money and capital markets, because they must accumulate insurance premiums
to build up funds to meet policy claims, and they must meanwhile employ these funds in loans and
investments. Thus, their financial functions are a necessary consequence of their proper business of
insurance.

Classification and Instruments of Credit

⚫ The various types of credit may be classified in many ways. it can be according to the status of the
debtor, according to the time period and according to purpose. Others differentiate credit as public
or private credit, monetized or non- monetized credit and other ways.

Public and Private.

This is based on the nature of the recipients of credit. Public credit includes all grants of credit to
governments: national, provincial, municipal and its instrumentalities. Private refers to all grants of
credit to non-governments: individuals, partnerships, corporations and other private institutions.

Secured and Unsecured.

This is according to the presence or absence of pledges of assets or security for the loan. Usually,
the most acceptable security or collateral is land with a title. Other forms of assets which are
acceptable are stocks, bonds, houses, machines, crops, and other valuable properties. Unsecured
loans are granted without security.

Purpose.

Credit may be classified according to the purposes for which the loans are used. Some of these are:

1. Commercial credit-includes the promise to pay of businessmen for the funds they borrowed in
the purchase of goods for productive or profitable ventures. There are the merchants, distributors
and manufacturers.

2. Agricultural credit-includes the promises to pay of farmers and farm organizations for the funds
they borrowed in the acquisition of farm inputs, such as fertilizers, chemicals, seeds, and facilities
for production and other agricultural operations.

3. Investment credit- is the promise to pay of individuals or business firms for the loans they obtain
in buying capital goods such as machineries, lands and construction of plants and factories. This is
also called industrial credit.

4. Consumer credit- constitutes all the obligations to pay of people for the money they borrowed for
consumption purpose, such as medical care, tuition fees, goods and other things for personal needs.

5. Speculative credit- is a type of credit which is used for dealing in securities or goods with the
intention of making a profit through favorable price changes.

-Time period.

This is a very simple way of classifying credit which involves the time period in the contract. These
are:

1. Short-term credit- is a loan which is payable in less than one year.

2. Long-term credit- is a loan whose maturity is from five years or more.
3. Intermediate credit- is a loan which matures only in one year and less than five years.
 C's of Credit
•1.Character. Character is the most important consideration in the proper determination of the
credit rating of an individual. The character of an individual is the aggregate of distinctive mental
and moral qualities belonging to him. it denotes his good moral built up by long years of honest
dealing. The character of the borrower indicates his willingness to discharge his financial obligation,
that is, to repay the loan as promised. However, it does not indicate his probable ability to pay.

•2. Capacity. As a basis of credit, capacity signifies the ability to pay when a debt is due. It need not
be stated very strongly that no matter how desirous an individual may be in discharging his financial
obligations, however, if he suffers from lack of ability to pay, that is, lack of adequate income, he will
represent and remain a poor credit risk.

One's capacity in business likewise is circumscribed, among others, by factors relating to income,
that is, the difference between sales and cost of operation

•3.Capital. For credit purposes, credit represents the financial strength of the risk, that is, it consists
of the amount and quality of goods and property, expressed in terms of money, which an individual
or firm possesses over and above, his financial obligations.

From the standpoint of mercantile credit, it may present the firm's property like equipment, building
and the like. A bank making loans to business concerns focuses its attention on the financial
statement filed by the borrowing concern.

•4. Collateral. Speaking of collaterals, creditors as a general rule would prefer loans or credits to be
backed up by collaterals as much as are necessary for their self-protection.

Thus, collateral must therefore be something of value, which can be easily converted into cash,
deposited as a pledge with a lender to secure the repayment of a loan if a borrower is unable to
discharge the loan obligation when due, the lender is free to sell the collateral and collect the debt
from the proceeds of the sale. The collateral, which may be required, may vary with respect to kind
of and amount sought to be obtained as a loan and the term under which the loan is granted.

As a common banking practice, the amount of the collateral must be 40% bigger than the
amount of the loan. Such a practice may be explained by the desire of the bank to protect itself
against undue fluctuations in the market value of the collateral that may take place during the
period of the loan obligation. Collaterals may partake of various forms, as real estate property.
fishpond, or corporate securities like stocks and bonds. Collateral however cannot and should
not be made as substitute for character as a basis of credit.

•5. Conditions. Economic conditions exert profound effect upon the grant of loans and credits. It
may be rightly mentioned that loans and credits may be extended at certain times and may be
denied at other times.

6. Country. Since, as had been stated time and again, the sale of goods and services in any part of
the world on credit involves risk, it follows that every factor should be carefully considered and
scrutinized insofar as they affect credit risk.

7. Currency. Not only is the stability of the country of importation an important factor to reckon
with in the consideration of credit risk in international trade transactions but, equally so is that
which pertains to that of currency. The risk of exchange must also be taken into account.

Confidence. After having indicated and discussed the various bases of credit, one is led to conclude
that, in the ultimate analysis, credit is founded on confidence - which by far is the principal C of
credit. For any credit transaction to take place, the businessman, whether he be a seller of goods or
services on credit must have confidence:

- on the character of the buyer, that is, whether he is trustworthy and, as such, represents a good
moral risk
-on the capacity of the buyer to enter into a valid contract and conduct his business profitability
-on the adequacy of the capital possessed by the debtor to support the transaction for which credit
is required
-on the fact that the collateral put up by the debtor is something of value and will not become
subject to wide and violent fluctuations in the market
-on the soundness of policies of the government of the country of importation in the case of foreign
trade
-on the stability of currency
Briefly, observed then, confidence is the cornerstone of every credit transaction the prime mover o r
of credit economy.

Credit Instruments
Instruments of credit are also classified in several ways. They vary according to purposes,
customs and government laws. Nevertheless, credit instruments which are commonly used by
people are either promises to pay or orders to pay.

Promises to Pay
1.Charge Accounts. It is simply an arrangement between the seller and the buyer. Charge account
credit is sometimes called book credit and it is usually not secured. It is used by retailers,
wholesalers' transactions and others.

2. Promissory notes. It is a written promise to pay a sum of money on demand or on a definite

future date to a designated person or bearer.

• "maker"- the person who promise to pay

• "payee"- the one to whom the promise is directed

3. Bonds- It is a written or printed acknowledgement of debt. It is a certificate of indebtedness.

Bonds are usually long term notes issued by the government and private corporations for the
purpose of financing their respective projects.