What it means
When a lender or supplier extends credit, it sets a ceiling based on how much risk it is willing to take. For an individual, the limit reflects income, existing debts and repayment history.
For a business customer, a supplier may look at financial statements, trade references, years in business and payment behaviour. Once the limit is reached, further purchases or borrowing are declined or require approval.
Some lenders allow transactions over the limit but charge a fee, so it is worth checking the terms. For businesses selling on credit, the limit is a core risk control.
Sales and finance teams agree limits for each customer, and orders that would take a customer over its limit are held until the customer pays down its balance or the limit is reviewed. This prevents a single large customer from creating a bad debt that the business cannot absorb.
Credit utilisation, the balance as a proportion of the limit, is an important health signal. High utilisation suggests a borrower is stretched, and credit scoring systems for individuals pay close attention to it.
Many advisers suggest keeping it comfortably below the limit, with lower being better. Limits are not fixed.
Lenders review them periodically and can raise or reduce them depending on performance or changes in the market. Borrowers who pay on time often get increases, and those who fall behind may see limits cut.
An unused limit still has value because it is a source of funding when needed. Companies often arrange revolving credit facilities as a safety net for short-term cash needs, paying a small commitment fee even when they do not draw on them.
Treasury teams treat the undrawn amount as part of the company's liquidity.
In practice
Real-world examples
Example 1
A building materials supplier gives a new contractor a credit limit of $15,000. When an order for $18,000 arrives, the system holds it until the contractor pays an overdue invoice and brings the balance down. The sales representative is told the reason, so the conversation with the customer stays friendly.
Example 2
A freelance designer has a credit card with a $5,000 limit and spends $4,600 on equipment. Her utilisation is 92%, so she makes a mid-month payment to bring it under 30% before the statement date.
Example 3
A manufacturer arranges a $2,000,000 revolving credit facility to cover seasonal stock purchases. It draws $1,200,000 in the busy season and repays most of it after the sales are collected. Interest is charged only on the amount drawn, so the cost falls as the balance is repaid.
Think of it
A credit limit is the maximum you'll let a customer owe you-your risk ceiling for that account.
Formula
Calculation
Credit utilisation = outstanding balance / credit limit
Available credit = credit limit - outstanding balance
A business has a credit line with a limit of $20,000 and a current balance of $7,000. Utilisation = $7,000 / $20,000 = 35%. Available credit = $20,000 - $7,000 = $13,000. If the business draws another $6,000, the balance becomes $13,000, utilisation rises to $13,000 / $20,000 = 65%, and available credit falls to $7,000.Case study
Seen in the real world
Alderbrook Foods is an illustrative, fictional wholesaler that supplied 120 restaurants on 30-day credit. Limits had been set when each customer signed up and were never reviewed, so one restaurant group had built a balance of $140,000 against an original limit of $50,000.
When the group closed three sites and delayed payment, Alderbrook faced a possible loss of nearly three times what it had intended to risk. The credit manager introduced an automatic hold at the limit and a six-monthly review based on recent payment history.
The following year, two other customers hit their limits and were asked to pay before further orders were released. In this illustrative case, enforcing limits kept the exposure within what the business could afford to lose.
Watch out
Common mistakes
- Treating the credit limit as money to spend, when it is borrowed money that has to be repaid with interest.
- Setting a customer's limit once and never reviewing it, even though their finances change and their payment habits may worsen.
- Using up the whole limit of a card or facility, which raises utilisation, removes headroom for emergencies and may harm the credit score.
Questions
People also ask
Why do lenders change credit limits?
Because the borrower's risk changes, so a better payment record can lead to an increase, and missed payments or a weaker financial position can lead to a reduction.
Does asking for a higher limit affect my credit?
A request can lead to a credit check, which may have a small temporary effect, but a higher limit can reduce utilisation if your spending stays the same.
How do businesses set customer credit limits?
They look at the customer's financial statements, credit reports, payment history and the size of the relationship, and often set the limit as a fraction of the customer's net worth or a multiple of its average monthly purchases.