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
Credit limits are determined by banks, alternative lenders and credit card companies based on 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. If someone takes out a home equity line of credit, for example, 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 way. Essentially, a borrower may spend up to the credit limit, but if they exceed that amount, they typically face fines or penalties in addition to their regular payment. If a borrower has spent less than the limit, they can continue to use the card or line of credit until they reach the limit. Credit limit and available credit are not the same thing.
If a borrower has a credit card with a $1,000 credit limit, for example, and they spend $600, they have an additional $400 that they can 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 is likely to increase the line of credit, which has a number of benefits. 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.
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 have the effect of hurting 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 that creditors lower their credit limits.