Personal Credit to Cover Business Expenses, Yay or Nay?

Businesses use credit to help manage their cash flow between payables (outgoing funds) and receivables (incoming funds).

Credit provides business owners with peace of mind that they have a cushion they can rely on in case of emergencies, to support their seasonality, and to cover other unexpected expenses.

While many businesses are well-versed on how to operate their business from within, there are still numerous businesses that use their personal credit lines to make business purchases, such as tools needed for a job, equipment to complete a project, or to simply make payroll while awaiting that government contract that is more than 90 days out.

But what is the downside of using personal credit to cover business expenses?

As we all know, your credit history is very important.  It impacts your life from all around. Credit can be a qualifier to get you approved for an apartment in a good neighborhood that has high ranking schools, getting a new job, and in most cases will influence your borrowing options and pricing.

Business credit products are generally not reported to the business owner’s personal credit bureau unless the account becomes delinquent.  This is actually a good thing!!

Why is it a good thing?

Well, let’s look at these two scenarios

Scenario 1:

John Doe owns ABC Plumbing Company LLC. John started his business about a year ago. Since John already had two credit cards with a limit of $50,000 combined, he thought it would be a good idea to use one of those cards for personal expenses and the other one for business expenses. John and his wife Jane Doe have a balance on one of those cards for $20,000. John figures, he’ll continue making the minimum payment while he focuses on building his business. After six months, he’s built up a balance of $25,000 on the other card earmarked for business use. He underestimated his start-up expenses but he has a solid plan to increase his income and retire those debts within the next year. Part of his plan is to transfer his debts to cards with lower interest rates. He thinks, “Since I’m using one of the cards for business purchases, I’ll just apply for a business credit card at my financial institution”.

Let’s evaluate what just happened. John and Jane Doe have two credit cards with a combined limit of $50,000. They already had a balance of $20,000 and racked up an additional $25,000 in debt over the last six months. They now owe about $45,000. Since they have only been making the minimum payments, the balance has not gone down. They apply for a new credit card to transfer their balance to a lower interest rate card. Their financial institution pulls their credit report and informs them that their credit request has been denied. Their credit scores were nearly perfect but have declined significantly over the last six months. How could this be?

One of the major components of the FICO credit score is based upon how you use your existing credit. A common way for this to be measured is by using a revolving credit utilization ratio. That is, how much you owe on your revolving credit lines in relation to your total available credit. The higher the ratio is the more of a negative impact it will have on your score.

Here’s how it impacted John and Jane:

Before

• Credit Card Debt: $20,000
• Credit Limit: $50,000
• Credit Utilization: 40%

After

• Credit Card Debt: $45,000
• Credit Limit: $50,000
• Credit Utilization: 90%

This increase in credit utilization had a large impact on their credit scores and ability to borrow in the future. This could have been avoided with a little bit of good planning. By getting a business credit card when they started the business, this information would not have impacted their personal credit. Make sure to check with your financial institution on how they report business credit. John and Jane could have also avoided this situation by saving enough money to cover the larger start-up expenses and by using their credit card only for short-term purchases that they could payoff within 30 days.

Every situation is different. At Sandia Area, we have the expertise and resources to help you with your cash flow management needs.

Scenario 2:

Bill Smith owns ABC Real Estate Company LLC. Bill buys foreclosed homes, renovates them, and resells them for a profit. Bill started his house flipping business about a year ago after several years of working as a real estate agent, learning the industry, and saving money. Bill Smith took the advice of his business banker and applied for both a business credit card and a business line of credit using the equity in his rental property as collateral. Bill was approved for a $150,000 business line of credit and $25,000 business credit card. Bill also had a personal credit card where he carried a balance of $500 out of $10,000 available line.  Bill uses his personal credit card strictly to pay for his family’s gas, car insurance, health insurance, and gym memberships. Bill made it a rule to never use his personal credit card for any of his business expenses.

Bill recently won a bid on a foreclosed home in a very nice neighborhood. To his surprise, the house was a total wreck and many repairs were needed before the house could go on the market.

Bill decided to use $20,000 from his business credit card and take an advance of $40,000 from his business line of credit to complete the repairs and get the house ready for sale.

Here’s how it impacted Bill’s credit:

Before

• Credit Card Debt: $500
• Credit Limit: $10,000
• Credit Utilization: 5%

After

• Credit Card Debt: $500
• Credit Limit: $10,000
• Credit Utilization: 5%

There was no increase in Bill’s credit utilization because his business expenses were not paid for by his personal credit card.

Although Bill had to use $60,000 from his available business credit, he knows that the house will be sold in less than 90 days because of its location being in a highly sought after neighborhood. During this time, Bill is able to take advantage of low interest rates, rather than using a hard money loan or alternative source of funding. Additionally, Bill had a low required monthly payment, which allowed him to maximize his cash flow and return on his investment.

Credit can have a major influence on how successful your business becomes.

Furthermore, financial institutions look at your debt ratios anytime you apply for new credit. Whether the credit is business or personal will have an impact on the way the financial institutions make their calculations.

A common debt ratio used by lenders is the debt-to-income ratio, also known as the DTI. Your debt-to-income ratio is calculated by taking all of your monthly payments on debt and dividing it by your gross monthly income.  This number measures your capacity to pay back the money you borrow. 

Most mortgage lenders consider a debt-to-income ratio of 45% or below to be in the healthy range.

When you use your personal credit to cover your business expenses, like John Doe above, you are doing yourself a disservice because you are affecting your debt-to-income ratio, making it harder for yourself to qualify for loan requests such as financing a home, a car, or obtaining new credit, if the need arises.    

When looking at the two scenarios above, John Doe will likely have a hard time getting approved for any new credit, whereas Bill Smith will not. So, be credit smart!

Come talk to us!  At Sandia Area, we have the know-how to help you make smart credit decisions.

Kawtar El Alaoui
Commercial Services Officer
Kawtar.ElAlaoui@sandia.org
505-256-6080