Most Americans deal with credit every day, usually in the form of a credit card. When they receive a credit card, it comes with a credit limit determined by the lender. The credit limit is the maximum amount of money the lender will extend to the borrower on a single account.
Anyone with a credit card or revolving line of credit should understand not only what is a credit limit, but also how credit limits work and affect their financial health. This guide will get you started.
- How Credit Limits Work
- How Lenders Determine Credit Limits
- Credit Limit vs. Available Credit
- Credit Limits and Your Credit Score
- Tips for Improving Your Credit
Say, for example, that a bank offers you a credit card with a $10,000 limit. You can run right out and charge $10,000 worth of whatever you’d like. You may use all or part of the available credit, but as soon as the total bill hits $10,000, you’ve reached your limit. At that point, you will not be able to use the card for another purchase until you pay back some of what you’ve borrowed.
These purchases are essentially a loan. When you swipe the card at a point of sale, the credit card issuer loans you the money by paying the merchant. You then have to pay this borrowed money back to the lender — with interest. The interest is what the lender charges you for the privilege of borrowing money.
Credit limits do not apply only to credit cards. Any type of revolving account that lets you borrow money as you need it has a credit limit. This includes charge cards issued by department stores and home equity lines of credit. Installment loans, like vehicle loans and mortgages, are not revolving accounts and do not have credit limits. Instead, the lender issues those loans as a lump sum.
When a borrower applies for a credit card or other revolving credit account, they go through a process called underwriting. The underwriter reviews and analyzes available data regarding the applicant, including their gross annual income and the way they manage their money. This suggests how likely it is they will repay or default on their loans.
Lenders give the highest credit limits to the people they think will pay them back, and they reduce their risk by offering lower credit limits to other borrowers. To determine this, they look at factors like the borrower’s credit history, income, number of credit accounts and the amount of available credit they have remaining.
Credit limits are not static, and the lender can change them as needed. Many lenders periodically review their accounts and increase credit limits for customers with a proven track record of managing their debt. Customers may also request a credit limit increase. At the same time, banks sometimes lower credit limits for customers who miss payments or keep high balances on their cards.
A credit limit is the total amount of money available to a borrower. For example, a credit card company might issue you a credit card with a limit of $5,000. That is the maximum amount of money you can spend using that card. Say you charged $500 to the credit card. The lender would deduct the $500 from the available credit. This leaves $4,500 as an available credit.
In most cases, the lender will deny charges for purchases greater than the amount of credit available on the account. Although some lenders will allow borrowers to exceed their available credit, this generosity comes with a price. They can — and most do — charge penalties for going over the credit limit.
Credit limits don’t directly affect your credit score. Instead, they are part of the formula that calculates your credit utilization ratio. This number — determined by dividing the amount of credit you’re using by the amount of credit you have available — indicates how you use and manage your available credit. As such, it plays an important role in calculating your credit score.
Lenders use the credit utilization ratio to predict how likely a borrower is to repay or default on the loan. High credit utilization suggests the borrower does not manage money properly or might not have the means to pay bills on time. For this reason, individuals who want to improve their credit scores should work to lower their balances and increase their available credit.
Find Out: What Is a Good Credit Score?
To get the best interest rates and top credit lines, you might need to improve your credit. Start by learning about the different credit score models and how they determine your score. Then check your current scores. When you do this, you should also find out which factors have the greatest effects on your scores so you know what spending habits you need to change.
For most people, the most important habits they need to establish are creating and sticking with a budget. A budget helps you keep track of where you’re spending your money so you can pay your bills on time. Creditors pay attention to the number of missed and late payments that appear on your credit report. When you can’t pay the bills you currently have, creditors question whether you will be able to pay them.
As you work to build or repair your credit, avoid relying on credit cards and opening new accounts. Instead, pay down outstanding debt. Not only does this lower your credit utilization ratio, but it also shows potential lenders that you’re able to manage your money and use credit responsibly. It takes time to increase your credit score, but you’ll qualify for better loan terms and enjoy greater credit limits when you have a higher score.
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This article has been updated with additional reporting since its original publication.