Credit Limit

Credit Limit

The credit limit of an account is the maximum amount that a borrower can withdraw or use from a credit line. This amount is established by a lender and based upon a borrower’s creditworthiness, payment history, relationship with the financial institution, and other relevant aspects of their credit and financial situation.

What is a credit limit?

Credit limits commonly apply to revolving credit accounts that allow the borrower to take money out of the account and pay back the outstanding balance at any point in time. The most common form of revolving credit is a credit card. Revolving credit accounts typically have a cut-off date when the lender charges interest on the outstanding balance of the account.

In the statements of most revolving credit accounts, there are three different amounts that provide information to the borrower about the account’s situation: credit limit, available credit, and outstanding balance. Here’s a detailed explanation of what each of them represents:

  • Credit limit: Credit limit indicates the maximum amount that the borrower can subtract from the credit account. The credit limit won’t change unless the lender decides to increase or decrease it, and it is not directly affected by payments or withdrawals made on the account. The lender does not use the credit limit as a reference to apply interest charges, as it merely indicates the size of the credit account.
  • Available credit: Available credit is the result of subtracting the outstanding balance from the account’s credit limit. At any moment, the borrower can withdraw or use an amount equal to or lower than the available credit for their financial needs. If the credit limit has been entirely used, the available credit will typically be zero. On the other hand, if the account hasn’t been used at all, the available credit should be equal to the credit limit. Finally, the amount of available credit varies depending on the payments and withdrawals made by the borrower throughout the billing cycles of the credit account.
  • Outstanding balance: The outstanding balance is the total amount currently withdrawn by the borrower. It is usually lower than or equal to the credit limit, and once the cut-off date is reached, this amount will be used by the lender as a reference to estimate the interest charge that’s applicable to the billing cycle. In some instances, the outstanding balance may exceed the credit limit of the account as fees, interest expenses, and commissions may be added to it, which means that, if the credit limit has been maxed out, these fees will go over the credit limit and will be incorporated into the total amount owed.

Understanding these three variables usually helps borrowers in their effort to manage their revolving credit accounts more efficiently.

How Do Lenders Define Credit Limit?

Each lender has their own way to determine a borrower’s creditworthiness and payment capacity to define the credit limits of a credit account. Broadly speaking, lenders use the following information to determine the amount of the credit limit for each account:

  • Credit scores: A credit score is a tool used by lenders to understand a borrower’s credit situation based on their past credit experiences. This score often ranges from 300 to 850, and traditional lenders commonly require a score higher than 600 to consider a borrower to be eligible for certain credit accounts. In most cases, the credit score is the primary factor in setting the credit limit of an account. Lenders typically assign a low credit limit to individuals with low scores and higher limits to those who have higher scores.
  • Payment history: A borrower’s payment history is also important to determine the credit limit of an account. If the borrower has consistently failed to pay their past financial commitments on time, the lender may be unwilling to assign a high credit limit. On the other hand, if the borrower has been punctual with the payments of their past or current commitments, lenders will consider them to be eligible for a higher credit limit.
  • Income and financial situation: The amount that a borrower earns each month (their personal income) is also important in deciding the credit limit of an account. However, it is not just the income that matters, as living expenses, debt service, and other financial commitments are also analyzed, and more importantly, their payment capacity. In this sense, a high-income individual with high expenses may be granted a low credit limit while a person with a lower income but significantly smaller expenses may be granted a high credit limit.
  • Client’s relationship with the lender: Most financial institutions and lenders value the relationship they have with their clients, especially if they have been clients for quite a long time. The number of years the client has been with the institution, the number of loans they have taken out and successfully repaid, and the average volume of transactions they make are potentially considered when determining the credit limit of their revolving credit accounts. 
  • Collateral involved: Some revolving credit accounts require collateral to be approved, including, for example, secured credit cards. The collateral involved is usually money from the borrower’s bank account that is held by the institution as a guarantee. If the borrower fails to repay the balance on time, they can take out a portion of those funds to cover the debt. In these cases, the amount of money that is pledged as collateral is frequently set as the credit limit of the account.

Credit Limits, Credit Scores, and Credit Utilization Rates

A borrower’s credit limit also helps to determine their credit score. In fact, the amount owed by a borrower relative to their total credit limit (also known as the credit utilization rate) affects 30% of the calculation of the credit score.

The credit utilization rate can be easily calculated by taking all of a borrower’s credit accounts and dividing their outstanding balance by their total credit limit. A high utilization rate may reduce a person’s credit score, while a low utilization rate tends to increase the score over time.

As a rule of thumb, it is recommended that borrowers maintain a credit utilization rate lower than 30% to increase their score. This can be done by limiting the use of credit lines to expenses that can be repaid before the cut-off date or by applying for a higher credit limit if the borrower’s financial and credit situation is in good standing to get approved.

How Can a Borrower Apply for a Credit Limit Increase?

The actual procedure of applying for a credit limit increase varies from one lender to another, depending on their internal functioning and policies. That said, borrowers are commonly approved for a limit increase only if certain conditions are met.

These are some of the most common reasons a lender would be willing to approve a credit limit increase:

  • An increase in the borrower’s personal income: If the borrower provides evidence that their personal income has increased, and the lender concludes that this new level of income is sustainable over time, the borrower might be granted a limit increase. This change can come from a new job or a new source of income that the borrower is now receiving.
  • An important change in the borrower’s financial situation: A change in a borrower’s financial conditions can also facilitate the approval of a limit increase. This is usually the case for individuals who had a significant amount of debt in the past but have managed to reduce their balances significantly. This new financial situation increases their payment capacity, and the lender might be willing to increase the credit limit as a result of this change.
  • A positive change in the borrower’s credit scores: Since credit scores are an important tool to assess a borrower’s creditworthiness, a higher score may allow the borrower to successfully apply and get approved for a credit limit increase.

It is important to note that applying for a credit limit increase commonly generates a hard credit inquiry. A high number of these inquiries may reduce the borrower’s credit score if the credit account or the increase is not approved as a result.

Limitless Credit Accounts

Certain lenders have created revolving credit accounts that have no pre-established credit limit. Even though this may sound as if borrowers can spend money as they please, these “no-limit” accounts usually have an undisclosed limit. This limit is frequently a high one, but it does exist, and the fact that lenders don’t explicitly disclose it makes it difficult for the borrower to estimate the credit utilization rate and the potential borrowing costs involved in using these credit accounts.

Only certain exclusive credit instruments truly entitle the borrower to an unlimited amount of money, and they are usually issued on a case-by-case basis by lenders to high-net-worth individuals.

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