For some reason, people often think that credit transactions create money. They do not. When you buy icecream, money isn’t created; you exchange money for the icecream. The same goes with credit transactions. The lender exchanges his money for a promise or a claim from the borrower, that he will give the money back at a future date. The borrower is not able to spend more in the present than he otherwise would be able to, that is true, but at the same time the lender can spend that much less. When the borrower returns the money, he must restrict his spending and the lender can spend more.*
When a company wants to borrow money, it sells a bond, which is a legal claim entitling the bondholder to a stream of cash payments from the bond issuer (i.e., the company). A bond is simply a standardized contract in which a company borrows money from someone else in the community. The bond price is the amount of money the company is borrowing.
When an individual wants to borrow money, he can make arrangements with various people, however, in many cases borrowers use the services of a credit intermediary, such as a bank. The bank is an intermediary between the ultimate lenders and borrowers. First, the banks acts as a borrower, when depositors lend their funds to the bank (and earn a certain interest rate on their deposits). Second, the bank uses these funds to act as a lender to people in the market who wish to borrow from the bank (and pay a certain interest rate on their loans).
A successful bank is able to earn enough money on the spread (the difference between the interest rate it charges borrowers and the interest rate it pays to depositors) in order to provide for itself.
Consider a young couple wanting mortgage to buy a new house for $200,000. They have to borrow money from multiple savers. If they went knocking door to door, trying to find 200 people who would each put up $1,000 in exchange for the couple’s signatures on a loan contract, they probably wouldn’t be able to find many takers and even if they did, the interest rate would be quite high.
With a bank it’s different, because it is less likely to lose the lenders’ savings than any individual borrower. Thus the lenders are willing to lend at a lower contractual interest rate. The bank can also afford to lend to the couple, because it has experts whose job is to evaluate the likelihood that the couple will make their mortgage payments on time. By making hundreds or thousands of loans like these, the bank reduces the damage of any particular loan default (when a borrower stops making repayments). So long as the bank has properly estimated the credit risks of its borrowers, the bank will absorb the expected number of delinquencies and defaults as part of the cost of doing business. Thanks to banks there isn’t going to be one lender who loses his life savings, but the loss will be spread among all the lenders, who will only earn a lower interest rate on their bank deposits than the borrowers are paying on their mortgages.
A popular form of credit transactions. When a customer buys something, their credit card issuer pays money to the store, and then records the loan on the customer’s account. You can see once again that there is no new money being created, only exchanged. It is the same as if the credit card issuer walked into the store, gave the customer the money in exchange for a signature promising to pay it back with interest, and then the customer hands the newly-borrowed money to the store clerk. The use of a plastic card just makes this process easier.
There are companies who sell lenders “scores” on each applicant to make it easier for the lender to determine if the borrower is likely to repay on time. A high credit score or a good credit means the applicant is responsible, poor credit or a low credit score means the opposite.
Secured and unsecured loan
The difference between a secured and unsecured loan: a secure loan has a collateral backing it up, which is usually the object being purchased with the loan. Typical example include a mortgage, in which the house (and land on which it sits) serves as collateral. If someone borrowed $10,000 to take a cruise, there would be nothing except memories to show for it down the road, whereas someone borrowing $10,000 to buy a new car could sell the car and pay most of the remaining debt f his circumstances changed.
A productive debt occurs for example when an entrepreneur borrows money in order to expand his or her business operations. In the ideal scenario, the company takes out a loan, expands its business, gets higher revenues and pays off the debt.
Taking a loan to go through college or medical school can also be a productive debt. The essential feature of productive debt is that the borrowed money is invested in order to increase the borrower’s future income, so that paying back the loan will not be a burden.
*Yes, some banks really do create new money when they advance a loan, but we are not going to discuss that today.