Your Credit Score & Your Credit Limit

Understanding your credit score, your credit limit, and how they are connected is a fundamental part of understanding and managing your financial life. It might seem complicated, but when you flesh out all the details, understanding how the system works isn't too stressful, and arming yourself with this information can be a great way of making beneficial financial decisions in the future. After all, knowledge is power. It's time to be empowered!

Here are a few points to help you understand how these two numbers can affect each other.

First Up: What is a Credit Score?
The music played at the end of a movie? Unfortunately, no. It's nowhere near as entertaining.

A credit score is a number that lenders assess when they decide who qualifies for a loan, what that person's interest rate will be, and how much they are qualified to borrow. The number represents that person's creditworthiness, based on an analysis of the applicant's financial history. The lenders don't generate the number themselves. They get it from one of three major bureaus: Equifax, Experian, and TransUnion. You can get it too, and it's a good idea to check your score regularly and keep track of where it's going.

What is a Credit Limit?
It may sound like the number of names Warner Brothers can legally roll at the end of a film, but again, there's a bit more to it. Well, okay, a lot more to it!

This term refers to the maximum amount any particular lender will let you borrow or the maximum amount you can put on your card. Card providers use your score to calculate your limit, and usually, a higher score will mean a higher limit. Your limit can also affect your score because it affects your utilization ratio, a key factor in calculating your score.

What is the Utilization Ratio?
The utilization ratio measures how much of your available credit you are using. Your utilization is your account's outstanding balance divided by its limit.

Here's a quick example: Let's say that Jane has a card with a limit of $10,000 and a balance of $5,000. Since Jane is using half of her available credit, her utilization rate is 50 percent ($5,000 balance divided by $10,000 limit equals 0.50).

Because a utilization ratio is often an important factor in determining a person's score, a ratio of 30% or less is best. So keep your card balances low.

Effects of Multiple Cards
Couldn't resist the bombardment of junk mail offerings? Got multiple cards?

Scoring systems will take not only the individual utilization ratio for each card but also the utilization for all cards into account. That's right; it's a double whammy. Just as mentioned above, having a low utilization ratio, (30% or less) is far better for your score.

Free Tip - If you have a bunch of cards, it's best to pay off the ones with small balances owed on them, and leave them alone. Pick two, (preferably with the best interest rates) and use those as your go-to cards instead. Having a helter-skelter array of small payments on multiple cards will have a negative impact on your rating.

Effects of Decreases
Decreases in your limit change your utilization ratio in a way that has an adverse impact on your score. Having it lowered by a lender will raise your ratio. This can also happen if an account is closed, whether you or the lender closed it.

Let's look at Jane again. Her card had an available limit of $10,000 and a balance of $5,000. Since she was using half of what was available to her, her utilization rate was 50 percent ($5,000 divided by $10,000 equals 0.50).

If her limit is decreased to $5,000, and her balance is at $5,000, she now has a ratio of 100% ($5,000 divided by $5,000 equals 1.00)! Dramatic change even though she didn't spend an extra dime.

Rough day for Jane. Ouch.

Effects of Increases
On the flip side, if a lender raises your limit, it will usually lower your utilization ratio and may even increase your score. Now we're talking!

Let's take another look at Jane's situation. Her card originally had an available $10,000 with a balance of $5,000. She was using half of her available credit and her utilization rate 50 percent ($5,000 divided by $10,000 equals 0.50).

If the total amount available on her card increases to $20,000, and her balance is still at $5,000, she now has a ratio of 25% ($5,000 divided by $20,000 equals 0.25)! Again, she didn't spend an extra penny but benefited from a dramatic change, nonetheless.

Not a bad day for Jane. Nice.

Final Word
Now you can see how your credit limit affects your credit score, and vice-versa. Lenders are going to review your score and use the result as the basis of their decision making when you apply for a loan or card. It will profoundly influence the card's maximum (or loan amount) offered, as well as the interest rate made available to you, which significantly affects monthly payments.

In turn, the limit will change your utilization ratio, and therefore your score.

All of these factors work hand-in-hand, so it's a good idea to understand them and use this knowledge to better your personal report. It's always a good idea to check your credit report several times a year, so you are familiar with what it contains and whether your score is improving, dropping, or staying the same. Don't forget to print or download the results! It's your money, your records, your future. So take charge!