A credit limit is the maximum amount of credit that a financial institution or other lender extends to a borrower. It represents the maximum amount of money the borrower can owe the lender at any given time.
In the context of a credit card, the credit limit is the total amount that the cardholder can charge to the card. For example, if a credit card has a $5,000 limit, the cardholder can make purchases up to that amount. If the cardholder exceeds the limit, the credit card company may charge a fee, decline transactions, or increase the interest rate.
For a revolving line of credit or a home equity line of credit (HELOC), the credit limit works similarly: it’s the maximum amount that the borrower can draw down or borrow at any given time.
Lenders determine credit limits based on a variety of factors, including the borrower’s credit history, credit score, income level, and the lender’s policies. The borrower’s behavior, such as their history of making payments on time, can also influence changes to the credit limit over time. For example, if a borrower consistently pays their balance on time and in full, the lender may choose to increase their credit limit. Conversely, if a borrower frequently misses payments or carries a high balance, the lender may decrease the limit or close the account.
Example of a Credit Limit
Let’s take the example of a credit card.
Imagine a person named Alex applies for a credit card at his bank. The bank reviews his application, which includes checking his income, employment status, and credit history. Based on this review, the bank decides to approve Alex for a credit card with a credit limit of $10,000.
This means Alex can spend up to $10,000 on his credit card. He can use it for various transactions, like shopping, dining, travel, etc., as long as the total amount doesn’t exceed $10,000. If he tries to make a purchase that would push his balance over the credit limit, the transaction may be declined, or he might be charged an over-limit fee, depending on the terms of his credit card agreement.
Each month, Alex receives a statement from his bank, showing the balance he owes. If Alex pays off his balance in full each month, he can continue to spend up to the $10,000 limit. If he only pays a portion of the balance, then the remaining balance is carried over to the next month and subtracted from his $10,000 limit.
For example, if Alex has spent $2,000 and only pays off $500 at the end of the billing cycle, he would carry a balance of $1,500 into the next month. This would leave him with available credit of $8,500 ($10,000 limit – $1,500 balance) for the next billing cycle.
If Alex consistently pays his credit card bill on time, and uses his credit responsibly, the bank may decide to increase his credit limit in the future. Conversely, if he misses payments or frequently carries a high balance, the bank could lower his credit limit or even close his account.