Formal source of credit includes all the sources for raising the credit from the institutions which are functioning under the guidelines of RBI or which work with specific rules and regulations. They are more reliable than informal sources. Banks and cooperatives are the main formal sources of credit. The main features of formal sources of credit are:
- Low-interest rates: The interest rate charged by the formal sources will be less because they are functioning under the guidelines of the RBI. The formal sources have a fixed rate of interest for different types of loans.
- Increased income: The formal sources will charge only a fixed rate of interest which will reduce the cost of borrowers to repay the loans. Thus the income with the borrowers after paying their loans back will be higher. Thus the savings and the standard of living of people will increase.
- Legal proceedings: The formal sources will function under a proper code of conduct and lenders cannot easily exploit the borrowers. They can use only legal measures to get their loans back. Thus their dealings would be more secure and fair.
- Limited reach: The requirement of collateral for taking loans from institutional sources makes it impossible for the poor to take loans from banks and other institutions. Also, private banks will not be ready to open branches in places with no business. Thus they have only limited reach in the economy.
- The credit from the informal source is getting loans from institutions that do not come under the purview of any legal entity. Credit from these sources moneylenders, friends, relatives, traders and employer can be included under the informal sources of credit. The main features of informal sources of credit are:
- A high rate of interest: The informal sources like moneylenders will charge any rate of interest which will lead to huge cost the borrowers to repay and lenders can easily exploit the borrowers.
- Fewer savings: The informal sources like moneylenders will charge any rate of interest which will lead to huge cost the borrowers to repay and lenders can easily exploit the borrowers. Thus only less income would be left with them after paying their loans back. Thus the savings with them would be minimal.
- Unfair means of extortion: The informal sources will not have any code of conduct and lenders can easily exploit the borrowers. They can use any illegal means to get their loans back. They may use their muscle power for the collection of loans. On the other hand, formal sources use only legal means in their dealings.
- Vast reach: The requirement of collateral for taking loans from institutional sources makes it impossible for the poor to take loans from banks and other institutions. Thus they have to rely on other informal sources. This gives them a wide reach in the economy. Thus it will be difficult to control them.
- Influence: The moneylenders and other informal lenders will be highly powerful and influential in society. Thus it would be very difficult to control their activities.
