Credit Limit

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.

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 can be troublesome when they allow overspending and 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 vs. 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 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. This has a number of benefits, including increasing the borrower's overall credit score and giving them 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 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 each account's credit limit, any high balances, and the current balances. 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 to 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:

What is a credit limit?

A credit limit is the amount of unsecured or secured credit that a lender will grant a borrower through a revolving loan vehicle like a credit card, personal line of credit or a home equity line of credit. Lenders grant credit limits based on multiple factors, including the borrower's credit score, other types of credit they have, income and their on-time payment history.

What is available credit?

Available credit is simply the unused portion of a borrower's credit limit at any given time. So, if someone has a total credit limit of $10,000 on their credit card or personal line of credit and they have already used $5,000, they would have the remaining $5,000 as available credit that they could access. Available credit can fluctuate throughout the billing cycle based on account usage. The opposite of available credit is credit utilization level - which tracks the percentage of the credit line that is being used at any given time.

What is a credit score?

A credit score is a calculated value that serves as a proxy for a borrower's creditworthiness or ability and likelihood that they will repay any debts on time according to the terms of the loan agreement. Credit scores are generated by credit reporting agencies such as Experian, Equifax or TransUnion and utilize formulas that assign weights and values to factors such as payment history, amounts owed, length of credit history and credit utilization. Credit scores are not the same thing as credit reports, the latter of which are simply records of credit account types and status that are reported to credit bureaus by lenders.