What Is a Credit Limit?
Your credit limit is the maximum amount you can borrow on a line of credit. For example, with a credit card, you can spend as much or as little as you want, up to your credit limit. The same is true for other loans, such as home equity lines of credit: Your credit limit is a pool of money from which you can draw. Once you use it up, you need to pay down your loan balance if you want to spend from that account anymore. Alternatively, your lender can raise your credit limit, based on your request or their decision to do so.
How Limits Affect Your Score
Your credit limit is an essential part of your credit score. For the FICO credit score, the most commonly used score for major loans like mortgages and auto loans, the “amounts owed” category accounts for 30% of your score. Amounts owed are the second most important category in a FICO score. VantageScores and other scores also calculate how much of your available credit you use. Why do credit scores care? If you borrow a substantial amount of money, you appear riskier. One way to estimate how likely you are to stop making payments is by comparing the amount that you can potentially borrow against the amount you are currently borrowing. It is best to borrow only a portion of what’s available to you and 30% or so is about as high as you should go. So, if you have a credit limit of $1,000, you’d keep your balance below $300 at all times. If you borrow up to your credit limit, lenders may worry that you’re facing financial troubles. They may wonder if you hit a rough patch and if you’ll be able to keep up with your payments. Computer programs scan your credit reports periodically and generate credit scores whenever there’s a change in how you use your credit. Also, a human may occasionally review your credit limits and loan balances (when you apply for a loan at a credit union, for example).
If You Pay in Full
What if you pay off your balance every month? That’s a wise practice, but your credit scores still might suffer when you max out your cards. Credit card companies and home equity lenders report your loan balance to credit bureaus on a regular schedule, not on a continuous or real-time basis. Thus, they might take a snapshot of your balance before you pay down your balance for the month. When that happens, the credit scoring model doesn’t know that you’re about to pay off 100% of the loan balance.
Pay More Frequently
If you love earning credit card rewards, or if you enjoy the other benefits of spending with a credit card, don’t let your account balance get too high. Instead, make extra payments during the month to keep your balance below 30% of your credit limit. Alternatively, you can request a credit limit increase to make it look like you’re using less of your total available credit, given the same account balance.
Installment Loans
When it comes to installment loans that you pay down gradually with a fixed monthly payment, there’s not much you can do. When your loan is new, your loan balance is high relative to your original loan amount. However, that’s typically not a big deal—the credit-scoring model knows which loans are installment loans and which loans are revolving loans (or open-ended loans, such as credit cards). It’s normal to have high balances on installment loans at the beginning, but it certainly helps to pay them down over time.
