Many factors come into play when you apply for a line of credit. As you probably
know, your creditworthiness is expressed by your credit score, a number based on
the size of your debt and how timely your debt payments have been in the past.
The higher the score, the more likely a financial institution will extend you a
line of credit.
When you apply for a line of credit, a lender also looks at your ability to repay
and your credit history. It evaluates how much money you make, how secure
and sustainable your job and lifestyle are and how you've paid your past debts.
For business lines of credit, a financial institution evaluates profitability and
business risk. It scrutinizes your business's profit/loss history, as well as any
risks like a large investment in a new technology that could impact your ability
to pay back the loan.
The HELOC serves as a good example of how your credit limit is determined.
With a HELOC, the limit of your line of credit is based on a calculation involving
the market value of your house. The financial institution determines your
limit by subtracting what you owe on your mortgage from a percentage (usually 75
to 80 percent) of the market value of your house. Let's say an appraiser values
your house at $500,000. You still owe $200,000 on your mortgage. A given bank offers
you an 80-percent line of credit. Here's the calculation for your line of credit
limit:
$500,000 x 80% = $400,000
You still owe $200,000, so
$400,000 - $200,000 = $200,000 credit limit
The financial institution may decrease this limit based on your credit history and
ability to repay.
For a business line of credit, the financial institution determines your credit
limit based on the value of the business assets you use to secure the line of credit.
Your office building, or other business real estate, is the most likely candidate.
A financial institution determines the interest rate on your line of credit by adding
an indexed percentage rate -- such as the prime rate or the lowest interest rate
you could possibly get from the bank - to a margin. This margin is affected
by your credit history, ability to repay, profitability and business risk, as well
as the bank's ability and willingness to take financial risks. Your variable
interest rate will increase and decrease as the chosen index increases and decreases.
Again, a line of credit is useful for people or businesses that face several large
costs over several years, but there are alternatives to lines of credit. A
home equity loan may finance a single large project, such as finishing the attic
so that the in-laws can move in. The high interest rates of credit cards tend
to be dangerous for large purchases that can't be repaid quickly. But if you
need to make a series of small purchases and can pay back the money fairly quickly,
a credit card might be a better choice than a line of credit.