Credit limit: What is a credit line and how do issuers calculate credit limits

The ability to use debt financing to generate working capital or fund an expansion can be a key to success for small businesses. As a startup, credit eligibility is usually dependent on the personal credit score and credit history of the owner. More established businesses may have a business credit rating from Dunn & Bradstreet or Experian Business.

In this article, we’ll review how credit limits are determined and discuss the various lending options available for a small business. We’ll also talk about how debt affects a company’s balance sheet and how to increase business credit limits. In the final section, we’ll introduce you to Ramp’s commerce sales-based underwriting program.

What is a credit limit?

A credit limit is the amount of money that an applicant is approved to borrow from the lender. That funding could be structured as a business loan, business credit card, or business line of credit. The credit limits on each of these are set in the lending agreement, but they may be reviewed later if the repayment terms and conditions are met.

Lenders may offer higher credit limits if the borrower is able to offer collateral for a secured loan. Business owners can also do an unsecured vs secured credit card comparison if a traditional loan or line of credit is not available. Collateralized financial products allow the customer to control their own credit limit. That can be appealing in certain cases.

Being approved for a higher credit limit isn’t always a good thing. In some cases, the borrower can take more than needed and bury the company in high interest debt. It’s best to do some thorough financial planning and analysis before asking for a specific amount of money. Better yet, apply for a line of credit instead of a loan.

What is a credit line? 

We were going to save this for the FAQ section, but it’s important enough that we thought we’d explain it here. A credit line, aka line of credit (LOC) comes with a credit limit just like a loan does. The difference is that the borrower is not required to take the entire amount in one lump sum. They can withdraw only what they need. That eliminates the over borrowing problem.

With an open LOC, the borrower can go back and borrow again after they pay off the balance owed. Many small businesses do this to better manage inventory purchases or to fund growth. The flexible fund flow makes business credit lines ideal for scenarios when invoice processing is required before new revenue starts rolling in.        

How do credit limits work?

Initial credit limits are determined by the lender during the credit approval process. Limits may be lower if they are based solely on a personal credit score. Businesses with higher revenue and a business credit rating should have access to higher credit limits. The criteria for that includes, but may not be limited to, the following three factors:

Payment history

‍Paying bills on time should be at the top of the list of business finance tips for small business owners looking to build a solid credit rating for their company. Those who practice this in their personal life may also have a higher personal credit score, which may or may not be a factor when applying for business credit.   

Total debt

‍Lenders want to know how much a company or individual already owes to other lenders or credit card companies before they’ll approve them for more funding. Total debt is a major variable in calculating new credit limits, but it’s always viewed in perspective to what the total income of the company is.    

Debt-to-income ratio

‍Small business debt may add up to a significant number, but the total amount of debt is less important than the ratio of debt to income (DTI). The company may still get approved for a higher credit limit if what’s owed is significantly lower than the incoming revenue. Lenders like to see DTIs at 50% or lower.  

How do my business credit score and limit interact?

A business credit score is calculated using variables that paint a picture of your company’s credit history. These include payment history, late payments, total revenue, and debt-to-income ratios. When lenders see a high business credit score, they’ll consider a higher limit on new loans. Credit card companies may also offer better credit card rewards for higher scores.

The downside is that missed or late payments will have a negative effect on the business credit score. You can avoid those by investing in a good small business accounting software to keep track of cash inflows and outflows. Ramp connects to several of them, including QuickBooks, and we help you track business expenses. We’ll explain below why that’s important.    

The problem with traditional credit issuers

Small business owners and startups are often frustrated by the low credit limits offered by traditional lenders. Many fail to meet the minimum income requirements or haven’t been in business long enough to qualify for a loan. Banks will encourage them to get a charge card or credit card and reapply when they’re more established.   

Of course, the credit card companies might deny a small business also. Sole proprietors and single owner LLCs frequently use their personal credit card and keep expense reports. Unfortunately, that means taking on high interest debt and leaving the company open to the IRS denying certain tax deductions. It’s not a good way to do business.    

How to manage your business’ credit limit

The first step in managing a business credit limit is to create a healthy financial culture in the company. That means paying bills on time and having a good cashflow management program in place. Adding in some spending controls and a real-time expense tracking system will help too. Ramp can provide both those for you, along with integrations to other key systems.  

If you can’t get a traditional business credit card, try applying for a prepaid credit card for business. Many of the companies that issue them report to business credit bureaus, so you can use a prepaid card to build business credit. A higher business credit score could get the lenders to give you a higher business credit limit, not to mention better rates and terms.  

Giving employees Ramp corporate cards is another way to control spending. How does that help you manage your business credit limit? Cutting back on spending frees up more cashflow to make sure bills get paid on time. Think in terms of a purchase card given to procurement with a set limit on it that can only be spent with certain vendors.   

What happens if I exceed my credit limit?

Going over the credit limit can’t happen with a small business loan. You only get a certain amount and that’s it. An LOC is flexible, but withdrawals are cut off when you hit your limit. Virtual credit cards for business can be tricky because the primary card holder might forget they gave one out. It happens more often than you might think.

The best way to avoid exceeding a credit limit is to make doing it impossible. Avoid using traditional credit cards that will let you go over the limit. They charge hefty fees for that. Use loans and LOCs only for business purposes and make your monthly payments on time. It’s also a good idea to pay a little extra each month so unexpected fees don’t put you over the limit.    

Startup funding simplified: Introducing Ramp’s ecommerce sales-based underwriting

Most problems in business have a solution if you proactively seek it. We’re going to make this one easy for you. Traditional lenders may not approve you for a loan because your revenue is too low, or your company hasn’t been in business long enough. Do you have ecommerce sales revenue coming in? Ramp’s sales-based underwriting might be a solution for you.

Ramp can often offer a higher (up to 30x) credit limit than competitors. We utilize connections to some of the biggest commerce platforms, web stores, and marketplaces in the industry such as Stripe, Shopify, and Amazon to underwrite credit limits for businesses using their commerce sales data. Best of all, you only need one year of sales data to qualify. Contact us today to learn more. Our team members are standing by to help you out.

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