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Closed-End Credit Definition
Closed-end credit is a kind of loan or credit that involves a complete disbursement of the agreed amount at the time of settlement, with the stipulation that the loan amount, interest and finance charges will be repaid within a specified date. Such credit can either involve the payment of the principal and interest in installments or as one single remittance at maturity.
A Little More on What is Closed-End Credit
Closed-end credit is a type of loan or credit agreement signed between a lender and a borrower that includes details about the stipulated amount borrowed, interest rates and charges applicable, and monthly installments payable (depending on the borrower’s credit rating). Procurement of a closed-end credit is a good indicator of the borrower’s healthy credit rating.
In most cases, closed-end credit revolves around a real estate or an auto loan, and is referred to as as an installment loan or a secured loan. Secured loans are usually disbursed by banks and other financial institutions. Contrarily, credit cards and home equity lines of credit (HELOCs) are open-end credits or revolving credits.
Borrowers typically use closed-end credit to finance expensive assets such as property mortgages, furnishings and fixtures, electrical appliances, automobiles and boats. While open-end credit allows loan terms to be modified, the same is not true for closed-end credit. Also, unlike open-end credit, closed-end credit does not offer available credit.
Closed-end credit mandates fixed interest rates (except mortgage loans that can have either fixed or variable rates) and monthly installment payments. These interest rates are decidedly lower than those offered by open-end credit. Moreover, both interest rates as well as payment terms show variances across firms and industries.
It is obligatory for borrowers to apprise the lender of the purpose of the credit and also pay a down payment if required. For a borrower with a good credit score, the lender may choose to waive the requirement for a down payment.
Closed-end credit also entails the enforcement of strict penalties for both prepayment (i.e. repayment of the loan before the due date) as well as payment delay and default. While penalty fees are usually the norm for delayed payments, it is not uncommon for lenders to repossess assets in case of defaults in loan payments by the borrowers.
The longer the term of the credit, the more interest is payable by the borrower over time. Most closed-end credit involves home mortgages and automobile or boat loans. In such instances, the title of the asset remains with the lender until the loan is repaid in its entirety, following which the title transfers to the borrower.
There are two loan types offered by closed-end credit:
- A secured loan, that make it obligatory for the borrower to pledge an asset as a collateral. Such loans have typically faster approval times.
- An unsecured loan, that is not protected by a collateral. Such loans have shorter loan terms.
References for Close End Credit
Academic Research on Close End Credit
The valuation of closed‐end investment‐company shares, Malkiel, B. G. (1977). The Journal of Finance, 32(3), 847-859. Malkiel’s paper puts forth certain theoretical principles regarding the valuation of shares of closed-end investment firms. Applying cross-sectional empirical approximations, he illustrates the correlation between discounts or premiums applicable to a fund and the determinants identified in the theoretical analysis.
A liquidity-based theory of closed–end funds, Cherkes, M., Sagi, J., & Stanton, R. (2008). The Review of Financial Studies, 22(1), 257-297. This article offers an economic justification for the existence of closed-end funds by constructing a liquidity-based model. Closed-end funds enable investors to invest in illiquid assets without facing the perils typically associated with open-end funds. The authors speculate the behavior of closed-end fund IPOs and explain their occurrence in waves in particular sectors at a given time. They also describe why funds are issued at a premium over their net asset value and why such funds often end up trading at discounted prices.
Truth in Lending-Rescission and Disclosure Issues in Closed–End Credit, Griffith, E. (1993). Nova Law Review, 17(4), 13. The Truth in Lending Act of 1968 sought to benefit consumers by making it obligatory for lenders to make certain disclosures pertaining to the terms of available credit in standard terminology. Consumers could now make educated credit decisions. However, this Act never regulated loan rates; it only sought to revamp the allocation of resources within the market.
Closed‐end funds: A survey, Dimson, E., & Minio‐Kozerski, C. (1999). Financial Markets, Institutions & Instruments, 8(2), 1-41. This paper peruses historical literature pertaining to discounts on closed-end funds, especially the correlation of the discount with the net asset value (NAV). It concludes that historical literature has been unable to offer a satisfactory explanation, leading some researchers to switch to models of limited rationality. The paper samples over 70 studies of closed-end funds (CEFs) and suggests directions that research could take in the future.
Home equity lending: Trends and analysis, DeMong, R. F., & Lindgren Jr, J. H. (1990). Journal of Retail Banking, 12(4), 41-45. DeMong and Lindgren, Jr. survey home equity lines of credit and home equity loans and register the mannerisms of home equity borrowers, emphasizing on the reasons why borrowers opt for such loans. Home equity lines of credit are popularly referred to as open-end credit since they allow borrowers to increase credit within a limit.
Some factors affecting awareness of annual percentage rates in consumer installment credit transactions. Parker, G. G., & Shay, R. P. (1974). The Journal of Finance, 29(1), 217-225. The Consumer Credit Labeling Bill of 1960 managed to stir up considerable public interest in interest rates. The Bill advocated the disclosure of annual percentage rates of finance charges to borrowers. This Bill paved the way for the Consumer Credit Protection ACt of 1968 and effected the Truth-in-lending Title I the following year. Nevertheless, studies conducted before the regulation period revealed the following premises regarding consumer knowledge about finance rates and charges:
Consumers were typically unable to evaluate percentage rates and dollar charges on transactions involving installment credit.
Consumers were liable to underestimate annual percentage rates.
Several borrowers underquoted annual percentage rates paid on transactions involving installment credit.
Consumers and credit disclosures: credit cards and credit insurance, Durkin, T. A. (2002). Fed. Res. Bull., 88, 201. Durkin’s paper infers that the following circumstances have caused a visible increase in consumers’ perception of credit matters: Enhanced disclosure legislation; Advancements in education; Widespread and frequent use of credit; Effective advertising media that are not specifically required to disclose percentage rates and charges. However, Durkin also noticed that some consumers actually tended to use lesser credit when disclosures inadvertently convinced them that credit is expensive.
Credit cards: Use and consumer attitudes, 1970-2000, Durkin, T. A. (2000). Credit cards: Use and consumer attitudes, 1970-2000. Fed. Res. Bull., 86, 623. Thomas Durkin conducts a detailed analysis of consumer attitudes over a period of three decades. His study has revealed a drastic increase in the use of credit cards, both as sources of payment and revolving credit. However, the extensive use of credit cars also raises two concerns: Consumers do not always fully understand the implications of using credit cards. The use of credit cards has encouraged over-indebtedness.
Credit card defaults, credit card profits, and bankruptcy, Ausubel, L. M. (1997). Credit card defaults, credit card profits, and bankruptcy. Am. Bankr. LJ, 71, 249. Ausubel’s paper illustrates the link between credit card defaults and bankruptcy. Statistics show a drastic increase in cases of bank credit card delinquencies towards the end of the 20th century. Personal bankruptcy filings also reached a record high around the same time. Both credit card defaults and bankruptcy increased at a time when the economy was reasonably healthy with a healthy GDP figure and relatively low unemployment.
The growth of consumer credit and the household debt service burden, Maki, D. M. (2002). In The impact of public policy on consumer credit (pp. 43-68). Springer, Boston, MA. The beginning of the 21st century witnessed record high household debt proportionate to availability of disposable income. Such an anomalous increase in debt caused widespread apprehension in the minds of financial analysts as to the financial wellbeing of American families. They argued that an acute shortage of disposable income could result in reduced spending.
An introduction to the frbny consumer credit panel, Lee, D., & Van der Klaauw, W. (2010). This paper presents the FRBNY Consumer Credit Panel – a comprehensive database of consumer debt and credit. The panel tracks usage of credit by both individuals and households on a quarterly basis. The credit usage information thus gathered is used to calculate variances in individual and household liabilities on a national scale.
Consumer credit scoring: do situational circumstances matter?, Avery, R. B., Calem, P. S., & Canner, G. B. (2004). Journal of Banking & Finance, 28(4), 835-856. Credit history can be a valuable tool for both borrowers and lenders. However, local economic conditions and individual events can hugely influence credit history scores. Failure to consider such factors would drastically affect the accuracy of the scoring systems. All the same, it isn’t practically feasible to incorporate situational data into scoring models.