Definition
A credit limit refers to the maximum amount on a credit account that a borrower can utilize for purchases, balance transfers and cash advances, as well as for interest and fees.
Analysis
The credit limit is determined by the lender depending on the creditworthiness of the applicant(s). Credit limits are placed on revolving accounts such as credit cards and lines of credit.
This restriction on borrowing keeps account holders from exceeding their ability to reasonably repay the debt incurred on the account. Credit limits may be adjusted by the lender to reflect increasing or decreasing consumer risk, as determined by account review inquiries, or by direct consumer behavior such as late payments.
Account holders also have some ability to adjust the credit limit on an account. A cardholder may request that a creditor reduce the credit limit if they are concerned about temptations to overspend. A cardholder may also request a credit limit increase if they feel that they need more available credit on the account. Such a request would be subject to approval by the card issuer.
A borrower that maxes out a credit card has used all of their available credit. In this case, finance charges on the account could cause the balance to exceed the credit limit. This could cause the creditor to assess an over-the-limit fee as a penalty for exceeding the credit limit.
The credit limit is reported to credit bureaus so that the credit utilization rate can be calculated and incorporated into the borrower’s credit score. On some cards, there is no established credit limit. This does not mean that the borrower may have unlimited charging privileges.
Instead, any charges over a predetermined amount (soft credit limit) may be approved or denied by the credit card issuer depending on a number of factors. On these cards with no preset spending limit, the credit limit reported is often either $0 or the highest balance ever placed on the card. This artificially inflates a borrower’s credit utilization rate, thereby decreasing their credit score.
Under the Fair Credit Reporting Act, consumers are guaranteed the right to correct any errors in their credit report. However, there is currently no recourse for a cardholder with no preset credit limit to update their credit report when it incorrectly shows $0 as the credit limit.
