What is 'Credit Limit'
Credit limit refers to the maximum amount of credit a financial institution extends to a client through a line of credit as well as the maximum amount a credit card company allows a borrower to spend on a single card. Lenders usually set credit limits based on information in the application of the person seeking credit.
BREAKING DOWN 'Credit Limit'To determine credit limits, banks, alternative lenders and credit card companies look at several pieces of information related to the borrower. They examine the borrower's credit rating, personal income, loan repayment history and other factors. If the line of credit is backed by collateral, the lender takes into account the value of the collateral. For example, if someone takes out a home equity line of credit, the credit limit varies based on the equity in the borrower's home.
How Do Credit Limits Work?
Whether a borrower has a line of credit or a credit card, the credit limit works the same. Essentially, the borrower may spend up to the credit limit, but if he exceeds that amount, he typically faces fines or penalties in addition to his regular payment. If he has spent less than the limit, he can continue to use the card or line of credit until he reaches the limit.
For example, if a borrower has a credit card with an $1,000 limit, and he spends $600, he has an additional $400 that he can spend. If he makes a $40 payment and incurs a finance charge of $6, his balance falls to $566, and he now has $434 in available credit.
Can Lenders Change Credit Limits?
In most cases, lenders reserve the right to change credit limits. If a borrower pays his bills on time every month and does not max out the credit card or line of credit, the borrower is likely to increase the line of credit. In contrast, if the borrower fails to make repayments or if the lenders sees other signs of risk, the lender may opt to reduce the credit limit.
How Do Credit Limits Affect Credit Scores?
On credit reports, each file in relation to a credit card or line of credit shows the credit limit of the account, the high balance and the current balance. Unfortunately, having a high credit limit and multiple lines of credit may hurt a person's overall credit rating. In these cases, new potential lenders can see that the applicant has access to a large amount of open credit. This fact sends a red flag to the lender simply because the borrower may opt to max out his lines of credit and credit cards, overextend his debts and become unable to repay them. Because high credit limits have this potential effect on credit scores, some borrowers occasionally request creditors to lower their credit limits.