Your credit scores are an indicator to lenders of your likelihood to repay loans or default. While your debt repayment history is one of the most important factors, there are other factors that can raise or lower your scores, sometimes even within a month. Your credit utilization is one of those elements, so it’s essential to understand your credit limits and how they affect your credit scores.
What are credit limits?
Your credit limits are the maximum amount you can borrow on a line of credit. For example, with a credit card, you can spend as much as you want, regardless of the amount, up to your credit limit. The same goes for other loans, such as home equity lines of credit: your credit limit is a pool of funds you can tap into. Once used, you need to repay the loan balance if you wish to access that account again.
Additionally, lenders can increase your credit limits based on your request or their decision.
How do limits affect your score?
Your credit limits are a fundamental part of your credit score. For the FICO credit score, which is the most widely used for major loans like mortgages and auto loans, the “amounts owed” category accounts for 30% of your score. Amounts owed are the second most significant category in the FICO score. VantageScores and other scores also calculate the amount of available credit you are using.
Why do credit scores matter? If you borrow a large amount of money, you appear riskier. One way to estimate the likelihood of you missing payments is by comparing the amount you can borrow with the amount you currently owe.
It’s best to only borrow a portion of the amount available to you, with around 30% being the maximum level you should aim for. So, if you have a credit limit of $1,000, you should keep your balance below $300 at all times. If you borrow up to your credit limit, lenders may become concerned about your financial problems. They might wonder if you’ve hit a rough patch and whether you’ll be able to keep up with your payments.
Computer programs periodically scan your credit reports and generate credit scores every time there’s a change in how you’re using your credit. Additionally, humans may review your credit limits and loan balances appropriately (such as when applying for a loan at a credit union, for example).
What if you pay in full?
What if you pay your balance in full every month? This is a wise practice, but your credit scores may still be affected when you reach your card limits. Credit card companies and home equity lenders report your loan balance to credit bureaus on a regular schedule, not continuously or in real-time. Therefore, a snapshot of your balance may be taken before you pay off your balance for the month. When that happens, the scoring model does not know that you are about to pay 100% of your loan balance.
It’s best to keep your loan balance below 30% of your credit limits, even if you pay your balance in full each month. Even though you’ll never pay interest, your credit scores may be affected when you allow your balance to approach your credit limits.
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More Frequently
If you enjoy earning credit card rewards, or if you appreciate the other benefits of spending with a credit card, don’t let your account balance increase significantly. Instead, make extra payments throughout the month to keep your balance below 30% of your credit limits. Additionally, you can request a credit limit increase to make it seem like you are using less of your total available credit, based on the same account balance.
Installment Loans
When it comes to installment loans that are gradually paid off with a fixed monthly payment, there isn’t much you can do. When your loan is new, your loan balance is high relative to the original loan amount. However, this usually isn’t a major issue – the credit scoring model knows which loans are installment loans and which loans are revolving (or open-ended, like credit cards). It’s normal to have high balances on installment loans initially, but it certainly helps to pay them down over time.
By keeping your loan balance relatively low, you can avoid negatively impacting your credit scores. As a result, you’re more likely to be approved for the best interest rates and terms when applying for a loan next time.
Source: https://www.thebalancemoney.com/do-credit-limits-affect-credit-315372
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