What Is a Credit Limit?

The term credit limit refers to the maximum amount of credit a financial institution extends to a client. A lending institution extends a credit limit on a credit card or a line of credit. Lenders usually set credit limits based on the information given by the credit-seeking applicant. A credit limit is a factor that affects consumers' credit scores and can impact their ability to obtain credit in the future.

Key Takeaways

  • The term credit limit refers to the maximum amount of credit a financial institution extends to a client.
  • Lenders usually set credit limits based on a consumer's credit report.
  • A lender generally gives high-risk borrowers lower credit limits because they lack capital and the ability to repay the debt. Low-risk debtors typically receive higher credit limits giving them greater flexibility when they spend.
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6 Benefits Of Increasing Your Credit Limit

Understanding Credit Limits

Credit limits are the maximum amount of money a lender will allow a consumer to spend using a credit card or revolving line of credit. The limits are determined by banks, alternative lenders, and credit card companies and are based on several pieces of information related to the borrower. These lenders examine the borrower's credit rating, personal income, loan repayment history, and other factors.

Limits can be set for both unsecured credit and secured credit. Unsecured credit with limits is often in the form of credit cards and unsecured lines of credit. If the line of credit is secured—backed by collateral—the lender takes the value of the collateral into account. 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.

Lenders will not issue a high credit limit for someone who won't be able to pay it back. If a consumer has a high credit limit, it means a creditor considers the borrower to be a low-risk borrower. That borrower has greater capacity to spend with a higher credit limit.

High credit limits may be troublesome as overspending may mean that the borrower cannot meet their monthly payments.

A credit limit works the same way regardless of whether the borrower has a credit card or a line of credit. A borrower may spend up to the credit limit, but if they exceed that amount, they may face fines or penalties on top of their regular payment. If the borrower spends less than the limit, they can continue to use the card or line of credit until they reach the limit.

Credit Limit Versus Available Credit

A credit limit and available credit are not the same. If a borrower has a credit card with a $1,000 credit limit, and the cardholder spends $600, they have has an additional $400 to spend. If the borrower makes a $40 payment and incurs a finance charge of $6, their balance falls to $566, and they now have $434 in available credit.

Can Lenders Change Credit Limits?

In most cases, lenders reserve the right to change credit limits. If a borrower pays their bills on time every month and does not max out the credit card or line of credit, a lender may increase the line of credit, which has a number of benefits. These include increasing the borrower's overall credit score and accessing more and cheaper credit.

In contrast, if the borrower fails to make repayments, or if there are other signs of risk, the lender may opt to reduce the credit limit. A reduction of the borrower's credit limit increases the balance-to-limit ratio. If the borrower is using a lot of their credit, they become a higher risk to current and future lenders.

Credit Limits and Credit Scores

A person's credit report shows the credit vehicles they use along with their accounts' credit limits, any high balances, and the current balance. High credit limits and multiple lines of credit are detrimental to a person's overall credit rating.

Potential new lenders can see that the applicant has access to a large amount of open credit. This is a red flag to a lender simply because the borrower may opt to max out their lines of credit and credit cards, overextend their debts, and becoming unable to repay them. Because high credit limits have this potential effect on credit scores, some borrowers occasionally request creditors lower their credit limits.

Advisor Insight

Derek Notman, CFP®, ChFC, CLU
Intrepid Wealth Partners, LLC, Madison, WI

When applying for credit, consider the following checklist to be the most prepared:

  • Make sure the lender knows why you need the money. Why are you asking for credit? Having a clear reason will make them feel more comfortable.
  • Have a personal financial statement already completed. The bank will ask for this, so be prepared.
  • Have your tax returns from the past two to three years – the bank will ask for this as well.
  • Be willing to list an asset of yours as collateral to secure some or all of the credit. This could be things like real estate, cash value life insurance, or a business asset. Don’t offer this right away, but use it as a bargaining chip.
  • Don’t be afraid to try and negotiate the interest rate on the credit.
  • Being prepared will show a lender that you are organized, serious, and hopefully make them feel you are a lower-risk borrower.