Credit is when a lender gives money to a borrower and the borrower promises to repay or return the money at a later date. The terms public and private credit typically refer to who is extending the credit. Public credit is debt issued or traded on public markets, while private credit is negotiated outside of public markets.
In this article, we will look at different elements related to public and private credit, in particular their pros and cons. Understanding the difference between public and private credit is important for business owners and consumers. Each type of credit has its unique benefits and drawbacks so it’s important to know which one would be the best option.
Public Credit
Public credit could be debt extended by banks, governments, or even corporate bonds. Common types of public credit are student loans, business loans, and mortgages. Public loans usually have lower interest rates and longer repayment terms than private ones.
How does public credit work?
Public credit offers loans to consumers who meet specific criteria. The criteria might vary depending on the type of loan. For example, the borrower must be enrolled in an accredited school and have a good credit history for a student loan. For a small business loan, the borrower must have a good business plan and be able to show that the loan will be used to grow the business. The government also limits how much money can be borrowed for certain loans.
What are the benefits of public credit?
- Low-interest rates
One of the main advantages of public credit is that it usually comes with lower interest rates than private credit. This is because debt can be investment grade, meaning it is less likely to default. Or the lender has extravagant requirements to be approved for the credit. Businesses and individuals will find much lower interest rates on public credit products like student loans and mortgages than they would on private credit products like personal loans and lines of credit.
- More flexible repayment terms
Another advantage of public credit is that it often comes with more flexible repayment terms than private credit. For example, many government-backed student loans offer income-based repayment plans that allow students to make lower monthly payments if their income is low. This can make public credit products much more affordable for borrowers who are struggling to make ends meet.
- Greater access to credit
Another advantage of public credit is that it often provides greater access to credit for borrowers with less-than-perfect credit histories. For example, the Federal Housing Administration (FHA) insures mortgages for borrowers with low credit scores. This means lenders are more willing to lend to these borrowers, even with poor credit.
Downsides of public credit
- Limited funding
While public credit may be easier to obtain than private credit, the available funding may be limited. This can make it difficult to finance large projects or expand a business. Businesses or individuals might have to supplement their public credit with private credit or equity financing.
- Crowded market
The public credit sector is crowded with many companies and individuals competing for limited funding. This can make it challenging to get financing, especially if a business is relatively new or small.
- Tied to government regulations
Public credit is often subject to government regulation, which can change over time. This can make it difficult to predict the cost and availability of financing in the future. Owners might have to adjust their business plans or find another source of financing if the regulations change.
Private credit
Private credit is another type of debt financing that is available to business owners and individuals. Private credit is also known as alternative lending. It can be used to finance a wide variety of projects or businesses.
How does private credit work?
Like public credit, private credit is like a loan that must be repaid with interest. The terms of the loan, including the interest rate and repayment schedule, will be determined by the lender. Borrowers will typically need to provide collateral, such as property or equipment, to secure the loan. There are also options for no-collateral loans, but these usually come with a higher interest rate.
Benefits of private credit
- Tailored financing
Private credit is often tailored to the needs of the borrower. This means that borrowers can choose the terms of the loan that best meet their needs. For example, a business can choose a longer repayment period with a lower interest rate if it needs more time to repay the loan. Or it can choose a shorter repayment period with a higher interest rate if it needs the money quickly.
- Increased flexibility
Private credit is also generally more flexible than public credit. This means that borrowers can use the funds for any purpose, including working capital, inventory, or expansion. Also, the funds are often deployed faster than public credit.
- Access to more capital
Another key benefit of private credit is that a borrower will generally have access to more capital than with public credit. This is because private lenders are not subject to the same regulations as public lenders. This means that they can lend more money and offer more flexible terms. So, if a company has big projects or plans to expand its business, private credit may be a better option.
- Faster approval
Private lenders also tend to have a faster approval process than public lenders. This is because they are not as bogged down by bureaucracy and red tape. So, companies that need financing quickly may find that private credit is the best option.
Downsides of private credit
- Higher interest rates
One of the main disadvantages of private credit is that it usually comes with higher interest rates than public credit. This is because private lenders are not backed by the government, and they are taking on more risk. So, they will charge higher interest rates to compensate for this risk.
- Shorter repayment periods
Another potential downside of private credit is that the repayment periods are often shorter than public credit. This means that the amount must be repaid more quickly. This can be a problem for businesses that are not generating a lot of cash flow.
- Credit check
More borrowers with bad credit are applying for private credit since they have lousy credit scores and most likely will not be approved for public credit. Having bad credit usually means that borrowers are more likely to default.
Different types of financing in private credit
- Merchant cash advances
A merchant cash advance (MCA) is a type of financing that gives businesses access to capital in exchange for a percentage of future sales.
MCA providers typically advance funds to businesses in exchange for a portion of the business’s future sales. MCA providers typically don’t require collateral, making them a good option for businesses that don’t have the assets to secure a loan. However, MCA providers usually charge high fees, so this type of credit is considered a very expensive form of financing.
- Lines of credit
A line of credit or LOC is an agreement between a borrower and a lender that establishes the maximum loan amount the customer can borrow. The borrower can access these funds as needed, up to the agreed-upon limit, and repay them with interest over time.
There are mainly two types of lines of credit:
2a. Secured LOC: A secured line of credit is backed by collateral. The advantage of a secured LOC is that it typically comes with a lower interest rate than an unsecured line of credit.
2b. Unsecured LOC: An unsecured line of credit isn’t backed by collateral. The advantage of an unsecured LOC is that it’s easier to qualify for than a secured line of credit. However, the interest rates are much higher in unsecured LOC.
- Factoring
Businesses mainly use factoring with customers who don’t pay their invoices immediately. With factoring, the company sells its receivables (invoices) to a third party at a discount. The third party then collects payment from the customer. This helps the business get the cash it needs right away, without having to wait for customers to pay their invoices. However, it’s important to note that factoring can be expensive. The business will have to pay interest on the loan and fees to the factoring company.
Public vs. Private Credit: Which is better?
There is no easy answer when it comes to choosing between public and private credit. It depends on the needs of the individual or the business. Public credit is typically cheaper than private credit. However, private credit may be a better option for companies that don’t qualify for public credit or need more considerable borrowing capacity to expand their operations. It’s essential to compare the advantages and disadvantages of each type of financing before making a decision so it’s important to choose the one that offers the best value to your business.
Conclusion:
Every business has different credit needs. There is no one-size-fits-all answer when it comes to choosing between public and private credit. Depending on the needs of the business, one option may be better than the other. These are significant differences between public and private credit that business owners should be aware of before deciding.
