Introduction to Credit Limit

When a lender offers you a Credit card or line of credit, it clearly specifies the maximum amount of credit that can be drawn by availing the credit card or line of credit. This maximum amount of credit is known as the Credit Limit (CL). Typically, the lending institutions decide the CL on the basis of the information provided by you as an applicant. A credit limit is a very important factor for personal liquidity as it can influence your credit score and, in turn, impact your ability to access future credit.

How Does Credit Limit Works?

Irrespective of whether you have a credit card or a line of credit, the CL works in the same way. As a borrower, you are allowed to spend until you reach the CL. In case you breach the CL, you will have to pay a penal interest in addition to the normal interest payment on the utilization, which also adversely impacts the credit score. Hence, it is advisable to maintain the utilization level (= Amount drawn / Credit limit * 100%) well below 100% as it results in a healthy credit score, which in turn leads to a lower borrowing rate.

Example

Let us take the example of David who has recently availed a credit card facility from a bank ABC Inc. The CL of the credit card is $5,000, which means that David can spend up to $5,000 with this credit card. Now, let us assume that David spent $3,000at the start of the current month. Determine the available CL if

1. David paid $1,500 at the end of the current month
2. David didn’t pay anything

Solution:

The available CL can be calculated as CL minus the credit availed during the month plus payment made during the month (assuming no interest payment for simplicity of the case). So, it can be seen that if you make payments, then your available CL increases.

Therefore, if David paid $1,500 at the end of the month, then the available CL can be calculated as,

Available Credit Limit = Credit Limit – Expense During the Month + Payment During the Month

• Available CL = $5,000 – $3,000 + $1,500
• Available CL = $3,500

On the other hand, if David didn’t pay anything, then the available CL can be calculated as,

Available Credit Limit = Credit Limit – Expense During the Month + Payment During the Month

• Available CL = $5,000 – $3,000 + $0
• Available CL = $2,000

How to Increase Credit Limit?

If you intend to increase the CL of your existing credit facility, then you have to do some or all of the following:

• Use thecredit facility: If you use the credit facility frequently and make the bill payments in full and on time, then it is likely that the bank may increase your CL.
• Provide updated income statement: If your income increased, then you should provide the updated income statement (latest payslips) to the bank and request for enhancement of the existing limit. The bank will be willing to increase the CL in such a scenario.
• Apply for a new credit facility: If your existing bank is not willing to increase your CL and you have a healthy credit history, then you can also apply for a new credit facility and it might come with a higher CL.
• Make all the bill payments on time: If you make all the bill payments regularly and on time, then your credit score will be healthy and any lender will see you as a low-risk borrower.So, you just need to be patient and wait as the bank may automatically offer you a higher CL.

How is Credit Limit Calculated?

Typically, the lending institutions take into account the following factors while calculating the CL:

• Credit History: Your credit score is one of the most important factors in the calculation of your CL. If you can maintain a clean credit history (no defaults or delayed payments), you can retain a good credit score, which in turn can result in a higher CL and lower borrowing rate. On the other hand, if your credit history is marred by a number of defaults indicating reckless credit behavior, then it is likely that banks may even shrink the existing credit limit. [Note: No credit history can also be harmful to a prospective borrower as the lenders end-up with no credit track record to rely on.]
• Debt-To-Income Ratio: The lenders also evaluate your income in order to assess the amount of debt that you can afford to repay. However, a higher income doesn’t guarantee a higher CL as the banks are more interested in your debt-to-income ratio. Yes, the banks also look at the amount of your existing debts and your debt servicing history. Effectively, a higher debt-to-income ratio results in a lower CL and vice versa.
• Credit Limit Offered By Other Lenders: At times, the banks also take cognizance of the CL offered by the other banks while calculating the CL of their facility. So, the limit of your other facilities can also be one of the factors for deciding the credit limit.

What is a Good Credit Limit?

In the UK, the average CL lies in the £3,000 to £4,000, while some higher income earners with a healthy credit history enjoy a credit limit of more than £10,000. On the other hand, the average credit limit in the US is around $22,750. So, it can be inferred that the definition of a good credit limit varies across locations and there can’t be any single right answer to this question.

Conclusion

• A CL is the maximum amount of credit that a lender extends to a borrower.
• The credit limit is calculated on the basis of the borrower’s credit history, debt-to-income ratio and existing CLs.
• Low-risk borrowers are offered higher credit limits and vice versa.

Recommended Articles

This is a guide to Credit Limit. Here we also discuss the definition and how does credit limit works? along with an example. You may also have a look at the following articles to learn more –

1. Interest Rate Swap
2. Times Interest Earned Ratio
3. Interest Coverage Ratio
4. Imputed Interest

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