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 information in the application of the person seeking credit.
A credit limit is one of the factors that affect consumers' credit scores and can impact their ability to get credit in the future.
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 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.
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.
Limits can be set for both unsecured credit and secured credit. Unsecured credit with limits usually involves 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 don't want to 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 sees the borrower as a low-risk borrower. That borrower also has more flexibility to spend how and when she needs to with a higher limit.
[Important: High credit limits may be troublesome, as overspending may make it difficult to make payments.]
How Do Credit Limits Work?
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 he exceeds that amount, he generally faces fines or penalties on top of their regular payment. If the borrower spends less than the limit, he can continue to use the card or line of credit until he reaches the limit.
- 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 may not be able to repay the debt. Low-risk debtors usually get higher credit limits, giving them greater flexibility when they spend.
Credit Limit Versus Available Credit
A credit limit and available credit are not the same thing. If a borrower has a credit card with a $1,000 credit limit, and she spends $600, she has an additional $400 to spend. If the borrower makes a $40 payment and incurs a finance charge of $6, her balance falls to $566, and she 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, a lender may increase the line of credit, which has a number of benefits. These include increasing the overall credit score and getting access to 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 limit to balance ratio. If the borrower is using a lot of his credit, he becomes a higher risk to current and future lenders.
Credit Limits and Credit Scores
A person's credit report shows his credit vehicles, along with the account's credit limit, the high balance, and the current balance. High credit limits and multiple lines of credit may hurt a person's overall credit rating.
Potential new lenders can see the applicant has access to a large amount of open credit. This 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 lower their credit limits.