How Credit Limits Affect Credit
Does your credit limit affect your credit score?
By Andy Sukhu, Founder & CEO of Y2K Credit Solutions
Short answer? Yes, depending on how much of it you use and specifically when your account balance is reported to credit bureaus. Allow me to explain and clarify the misconception.
First off, let’s discuss what a credit limit is.
Your credit limit is the maximum amount you can borrow.
If you have a credit card, you can spend up to your credit limit. The same is true for other loans, such as home equity lines of credit: your credit limit is the pool of money from which you can draw from. Once you use it up, you have to pay down your loan if you want to spend from that account anymore (alternatively, you might be able to get your credit limit raised).
How Credit Limits Affect Credit
Your credit limit is an important part of your credit score. For the FICO credit score (the most commonly used score for getting major loans like mortgages and auto loans), the “amounts owed” category accounts for 30% of your score – it’s the second most important category.
What is the FICO score looking at?
If you borrow a lot of money, you appear more risky. One way to estimate how likely you are to stop making payments is by comparing the amount that you can borrow against the amount that you do borrow.
In general, it is best to borrow only a portion of what’s available to you; 30-35% is about as high as you should go (so if you have a credit limit of $1,000, you’d want to keep your balance below $350 or so at all times).
If you borrow as much as they let you get away with, lenders will worry that you’re pushing it, and they’ll begin to wonder if you’ve hit a rough patch and if you’ll be able to keep up with your payments. Of course, this is all done by computers so nobody actually worries – a computer just looks how much you’re using, does some computations, and spits out a lower credit score.
If You Pay in Full
What if you pay off your balance every month?
That’s a wise practice, but your credit scores still might suffer. What matters most is what your lender (the credit card company, or your home equity lender) actually reports to the credit bureaus. They might report the amount you owe at some point in time before your payment arrives – so the credit scoring computers don’t know that you’ve paid off the balance. As a result, it’s best to keep your balances low even if you never pay a penny in interest.
If you love getting credit card rewards (or if you just enjoy the other benefits of spending with a credit card), don’t let your account balance get too high. You can make extra payments during the month if you want to keep your balance low, or you can request a credit limit increase to make it look like you’re using less of your total available credit.
When it comes to installment loans that you pay down gradually with a fixed monthly payment, there’s not much you can do. When your loan is new, your loan balance will be very high relative to your original loan amount.
However, this isn’t a big deal – the credit scoring model knows which loans are installment loans and which loans are revolving (open-ended, such as credit card) loans. It’s normal to have high balances on installment loans at the beginning, but certainly helps to pay them down over time.
Have questions? Need help managing your credit? Let’s talk!
Call me and my team at (877) 552-1377.