Credit Limit - How Does It Affect Your Credit Score?

Credit limit is not an alien term for most credit card users. Your credit limit decides the maximum amount that you can spend using the card while shopping or booking flights, hotels, etc. However, if you use the entire credit limit, you will land yourself in trouble.

Wondering how? Let’s take a closer look.

Why is Credit Limit Important?

A lower credit limit restricts the user from impulsive buying, whereas a higher credit limit offers flexibility in spending.

However, an excessive credit limit can also push you towards a debt trap.

Banks decide the credit limit based on the risk they are willing to take in lending money.

How Is It Determined?

Banks decide customers' credit limit based on various factors:

• Credit score - It determines the creditworthiness of the borrower. Hence, if you have a low credit score, it indicates that you might not be disciplined when it comes to credit repayment. A lender won’t be willing to give you an unsecured credit card (regular card) considering the significant amount of risk involved in doing so. In case a creditor eventually agrees to approve your application, you will get a low credit limit.

• Income - Your income is another significant factor that the bank will consider while determining the credit limit. Here, the crux is that if you have a high income or healthy cash flow, the bank would be willing to offer you a credit card.

• Debt to income ratio - Along with your income, this is another parameter that banks consider. If you have more debts than income, you may not be approved for a credit card in the first instance. However, if you have unused credit on other cards, the lender will consider it a positive sign for granting you a higher credit limit.

• Limit on other cards - If you have already built your credit, banks may also take a cue from the other card issuers while deciding the credit limit. This is especially true if you are going for two different variants. For instance, say you were given a credit limit of Rs.50,000 on your last HDFC credit card; then it is not likely that you will be eligible for a credit limit of Rs. 1Lakh on an American Express Elite card.

How Does It Affect Your Credit Score?

Having a credit limit doesn’t mean that you should use it entirely. If you do that, your credit score will slump to an extreme low. This is where the credit utilization rate comes in. You can determine it through the given formula:

Credit utilization rate = Credit card balance (amount of money you spend) / credit card limit set by the bank

It is considered healthy to keep your credit utilization rate below 30%. However, if your expenses are higher than the credit limit, then request the card issuer for an increase in the credit limit - either by asking directly or through their website. Remember that your request for credit limit enhancement can generate a hard credit inquiry, which can affect your credit score by some points.

• Note: You can only request an increase in credit limit if you have used the card for a minimum of six months and have a decent payment history.

• Getting a high credit limit can only help if you keep the utilization below 30%. If you overspend, you could fall into a well of debt.

To Wind Up

Using your credit limit wisely is the only path towards a happy and healthy credit life. Also, make sure that you monitor your credit report regularly to keep a tab on all credit activities.

If you are wondering where to check your credit report for free, you can always use mymoneykarma’s credit score tracker.