Credit Score and Credit Limits
There’s been much debate about the relationship between the credit score and credit limits of your account. Naturally, consumers would love to know what their credit limits are going to be ahead of time. It gives you more insight into how much money you’ll be able to spend and plan accordingly.
However, such information is not shared lightly by credit card companies. After all, that’s how they make money. It’s entirely understandable that they’d like to keep their process a secret. And while we’ll probably never know the inner working of companies’ credit limit formulas, we can make some logical deductions.
You probably already know that your credit card plays a role in determining your credit score. But did you know it’s the credit limit, in particular, that’s the most contributing factor? It’s time to dig into what credit card companies cannot keep a secret even if they wanted to.
What Is a Credit Limit?
A credit limit is the amount of credit that a credit card company (card issuer) will extend to you. In other words, a credit limit, or credit line, is the maximum amount of money you can borrow from a financial institution.
We can differentiate preset and no-preset credit limits. When a card issuer determines your credit quality, they’ll set a card limit that it deems appropriate given your circumstances. That’s in the case of preset credit limits, and that’s the kind that most people get.
On the other hand, no-preset credit limits allow for dynamic and flexible use of credit. They’re far less common than the preset ones.
How Is Your Credit Limit Determined?
First of all, it’s important to point out that credit card companies are the ones who determine what your credit limit is going to be. Through the process of underwriting, they decide what your limit should be. The process itself involves mathematical formulas and not a small amount of testing and analysis.
Due to the process of underwriting, card companies know who to approve, what the rate’s going to be, as well as the credit limit.
Now, as we’ve already mentioned, credit card companies run a tight ship when it comes to sensitive data. And you better believe that setting credit limits and performing underwriting is highly confidential.
In other words, no one outside of those companies knows what all the contributing factors are. For one, the mathematical formula they rely on is considered to be a trade secret. No way credit issuers would give up on that sort of information. Secondly, there isn’t just one formula in existence – each company relies on a different calculation to determine the credit limit.
While we don’t have access to their formulas, we can use cold logic and come to our own conclusion about what factors determine the credit limit. There seems to be a direct correlation between credit score and credit limits. For example, people with a higher credit score seem to have access to much better credit limits.
Another more obvious factor is your history with the creditor. They’re less likely to provide you with a decent limit if you’ve already proven to be a high-risk borrower.
So, to get the best possible limit on your account, it’s crucial you maintain a healthy credit. That entails paying your bills on time, having a decent credit history, and removing negative items from your credit report whenever you can.
Some things you don’t get to control, however. For example, the current economic environment can also play a role in determining the limit.
Understanding Default Rates
Your credit score influences more than just the limit that will be set on your credit card. It has a direct impact on the default rates as well. Remember, it’s up to the credit card issuer to decide what the rate’s going to be.
The default rate is also known as the penalty rate. It is the percentage amount you’ll pay on any outstanding loans that the lender had to write off as unpaid after a certain period of time. On average, a loan is in default if it’s been 270 days late. At that point, the loan is transferred to a collection agency.
Depending on the quality of your credit score, the default rate changes as well. For example, a consumer with a good FICO score (670-739) may be looking at a rate of 10%. On a $1,000 credit limit, that’s a default rate of $100. However, those consumers with an excellent score (over 800) might end up with a negligible 1% default rate. On the same $1,000 limit, that’s only an additional $10 penalty.
How Can Your Credit Card Limit Affect Your Score
Your credit score can have an impact on the card limit and vice versa. The main factor here is the credit utilization rate. In reality, it’s the same thing as the debt-to-credit ratio.
The credit utilization rate represents your overall use of the credit available to you. The closer your credit balance is to the limit, the higher the utilization is. You can calculate your credit utilization rate by dividing your credit card balance by your total credit card limit. The result you get represents your utilization percentage and is a factor that goes into determining your score.
The trick is keeping your credit utilization as low as possible. Even if you have a limit of say $1,000, it doesn’t mean you should keep maxing out your credit card. Most lenders and creditors find debt-to-credit ratios below 30% acceptable.
But why does this affect your credit score? The answer is that consumers who tend to max out their credit come off as high-risk borrowers who’ll have trouble repaying the debt.
What you can do to keep utilization low is to be more mindful of your spending habits. In addition to that, having multiple credit cards can help. If you spread the utilization across several cards, lenders will generally look more favorably upon you. The same goes for credit history – the shorter it is, the less likely you are to have a good score.
Can You Exceed Your Credit Limit?
Before the Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009, it was possible to go over the credit limit. When that happened, you ended up paying over-limit fees.
However, since CARD, you have to willfully opt in. That means you acknowledge that you’ll be paying a fee in case of exceeding the limit. It also means that your card won’t be rejected in the most inconvenient of times.
Do keep in mind that, even with the opt-in, you still won’t be able to use the credit card if you’re already past the limit.
Improving Your Score
With all that said, it’s clear that the credit limit and score influence one another. To gain a better offer on a limit from your credit card company, you need to raise the score first. To that end, you could hire the services of professional credit repair companies such as White, Jacobs and Associates. They will hook you up with an expert credit analyst that will be able to answer all your questions about credit and solve your credit problems.