Bank credit is extended when a lender such as a bank or other financial institution offers money to a borrower who agrees to pay it back with interest in a defined period of time. It can help you pay for a variety of purchases if you don’t have the cash on hand.
Let’s dive deeper into what bank credit is, how it works, and its pros and cons.
Definition and Examples of Bank Credit
Bank credit refers to how much money you can borrow from a lender. You can use it to finance a house, car, home improvement project, or anything else. Once you get approved and accept the credit, you’ll need to repay it, usually with interest via fixed monthly payments over an agreed term.
Imagine you want some cash to cover kitchen remodeling. You find a lender you like and apply for the bank credit. The lender approves you for $30,000. This means it may lend you up to $30,000, but you don’t have to borrow the full amount.
If your kitchen remodel will cost $20,000, this is great news because you’ll be able to pay for it completely with the credit. But if you need $40,000 for the remodel, you’ll need to shop around for a lender who will approve you for more money or find another way to cover the remaining $10,000.
- Alternate names: Credit, line of credit
How Bank Credit Works
There are a number of factors that help a lender determine how much bank credit to extend to you. Most lenders will pull your credit history to get an idea of what kind of borrower you are. The higher your credit score is, the more money you’ll likely be able to borrow.
They may also review your income and employment history to determine if you can afford to pay them back. Your debt-to-income ratio, or DTI, (your monthly debt payments divided by your gross monthly income) will be evaluated, too. Many lenders prefer a DTI ratio no higher than 43%.
If you apply for secured credit (more on this below), a lender will consider how much your collateral backing up the loan is worth. In addition, it will look at any debt secured to the collateral and subtract that amount from its value.
If you apply for bank credit but don’t get approved for the amount you want, work to increase your credit score and lower your debt-to-income ratio before applying again.
Types of Bank Credit
The two types of bank credit are secured credit and unsecured credit. Secured credit is backed by collateral, which is a valuable asset, like your house or car. In the event you fail to repay your debt, the lender may seize your collateral. Secured credit may be offered in the form of a mortgage or a home equity loan, for example.
Unsecured credit is not tied to any collateral. This means the lender won’t be able to claim any of your assets if you default. It can, however, report your failure to pay to credit bureaus and put a negative remark on your credit. Because unsecured credit is riskier for a lender than secured credit, it’s usually more difficult to obtain. A few examples of unsecured credit are student loans, personal loans, and credit cards.
Lenders usually charge a higher interest rate for unsecured credit than secured credit because of the greater risk involved.
Pros and Cons of Bank Credit
Bank credit comes with several notable advantages and drawbacks, including:
May build or improve credit
Some lenders have lenient requirements
Can lead to unmanageable debt
You may not get approved
Can hurt credit score
- Flexible: Bank credit can allow you to cover major expenses whenever you’d like, even if you don’t have the cash on hand.
- May build or improve credit: As long as you repay the money you borrow and don’t miss any payments, bank credit may build your credit or boost your credit score.
- Some lenders have lenient requirements: Depending on the lender you choose and amount of money you need, you may get approved for bank credit even with poor credit or a high debt-to-income ratio.
- Can lead to unmanageable debt: If you borrow more than you can comfortably afford to repay, bank credit may steer you into a cycle of debt.
- May not get approved: There’s no guarantee a lender will approve you or lend you as much as you want.
- Can hurt credit score: You may hurt, rather than help, your credit if your payments are late or missed.
While there are lenders that offer bank credit to those with no credit or bad credit, they aren’t always reputable, and may charge you a sky-high interest rate.
- Bank credit refers to the total amount of money you can borrow from a lender.
- The two types of bank credit are secured and unsecured.
- Factors such as your credit score, income, and debt-to-income ratio will play a role in how much bank credit you can get.
- You can use bank credit to pay for various purchases, like a house, car, wedding, home improvement project, or even a vacation.