Credit Limit

Definition

A credit limit is the maximum amount of credit that a lender will extend to a borrower. It represents the maximum amount of money that can be borrowed or charged on a credit card or other credit account before the account reaches its limit and additional credit is no longer available.

5 Must Know Facts For Your Next Test

1. The credit limit is set by the lender based on the borrower's creditworthiness, income, and other factors.
2. Exceeding the credit limit can result in fees, a lower credit score, and potentially the account being closed.
3. Maintaining a low credit utilization ratio, typically below 30\%, can help improve a borrower's credit score.
4. Credit limits can be increased over time as the borrower demonstrates responsible credit management.
5. The credit limit is an important consideration in receivables management, as it affects the maximum amount of credit that can be extended to customers.

Review Questions

• How does the credit limit affect a borrower's credit utilization and credit score?
  • The credit limit sets the maximum amount of credit available to the borrower. A higher credit limit allows the borrower to maintain a lower credit utilization ratio, which is the amount of credit used compared to the total available credit. A lower credit utilization ratio is generally viewed favorably by lenders and can help improve the borrower's credit score. Conversely, exceeding the credit limit can negatively impact the credit score and may result in additional fees or penalties.
• Explain the role of the credit limit in receivables management and how it can affect a company's credit policies.
  • In the context of receivables management, the credit limit is an important consideration for companies when extending credit to customers. The credit limit sets the maximum amount of credit that can be provided to a customer, which helps the company manage its risk exposure and ensure that the customer does not exceed their ability to pay. Companies may adjust their credit policies, such as the credit terms or the credit approval process, based on the customer's credit limit to ensure that the receivables are managed effectively and the risk of nonpayment is minimized.
• Analyze how changes in a customer's credit limit can impact a company's receivables management strategies and financial performance.
  • $$\text{Suppose a company has a customer with a credit limit of \$10,000. If the customer's credit limit is increased to \$15,000, the company may be able to extend more credit to the customer, potentially increasing sales and revenue. However, this also increases the company's risk exposure, as the customer now has a higher limit to potentially default on. Conversely, if the customer's credit limit is decreased, the company may need to adjust its receivables management strategies, such as requiring more frequent payments or reducing the credit terms offered to the customer. This could impact the company's financial performance, as it may lead to lower sales or increased collection efforts. The credit limit is a critical factor in receivables management, and changes to it can have significant implications for a company's financial health and operational strategies.}$$

Related terms

Credit Utilization: The ratio of the amount of credit a person is using compared to the total amount of credit available to them.

Credit Score: A numerical representation of an individual's creditworthiness, used by lenders to determine the risk of lending to that person.

Revolving Credit: A type of credit that allows the borrower to repeatedly access funds up to a certain limit, pay off the balance, and then access the credit again.