5 Questions To Ask About the Impact of Credit Limits on Your Finances

You probably know what a credit limit is, but as a refresher: It’s the amount a bank or other financial institution is willing to lend you to spend on a line of credit. Once you reach that limit, you can’t put anything else on that line of credit. It’s basically a loan that you get charged interest on if you don’t pay it back by the time your credit card bill is due.

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Of course, credit cards aren’t the only lines of credit available. You’re also taking out a line of credit when you have a mortgage, get an auto loan or take out a home equity loan.

What you might not know is that your credit limit affects your credit score and beyond. Here is a look at how credit limits work, how you can improve your credit and how you can raise your credit limit if you need to.

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How Are Credit Limits Determined?

When you apply for a line of credit, you’ll undergo an evaluation process, often done by an underwriter. The underwriter will take a look at your annual income, your credit history, your payment history — i.e. paying rent and bills on time — and how much credit you’re already using.

From there, a determination will be made basically on how trustworthy, or “creditworthy,” you are, and they’ll extend a line of credit — or decide to deny one — accordingly.

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What Happens If I Go Over My Credit Limit?

This depends on who’s lending it. Most likely, your card will be declined.

Some credit card companies or banks might let you spend over your limit, but then will charge a fee. Usually, if it’s a one time occurrence, it won’t affect your credit score. However, if you have a line of credit that continues to stay over the credit limit, then it most likely will be reflected on your credit report.

What’s the Difference Between Available Credit and My Credit Limit?

Your available credit is the total amount of credit that financial institutions have extended to you. Your credit limit is a figure specific to each line of credit.

For example, if you have one credit card with a $2,000 credit limit and another credit card with a $10,000 credit limit, your available credit is $12,000. However, your credit limit on the first card only reaches $2,000.

Additionally, your available credit decreases every time you use it. So, going back to those credit cards in the example: If you buy a $1,000 TV with the first credit card, your credit limit is still $2,000, but your available credit on that card is only $1,000 — $11,000 combined between both cards — because you’ve used the rest. If you pay off the full balance, your available credit goes back up to the credit limit.

What Is My Credit Utilization Ratio?

This is where it’s especially important to know the difference between available credit and credit limits. Your credit utilization ratio determines about 20% of your credit score. The ratio is calculated by dividing the amount of credit you’re using by the amount of credit you have available.

Back to the example above, with the $1,000 TV purchase, $1,000 becomes the amount of credit you’re using, while $12,000 is your total credit. The credit utilization ratio, or percentage, would then be $1,000 divided by $12,000, or about 8%.

Credit bureaus look at this percentage when determining if you are a creditworthy borrower. The Consumer Financial Protection Bureau (CFPB) recommends keeping your credit utilization rate under 30% and paying off your credit card every month.

If your credit utilization rate goes higher than 30%, it’ll most likely be flagged in your credit report that you are using a large amount of credit and haven’t paid it off yet. This could be a red flag for lenders.

How Can I Raise My Credit Limit?

With many credit cards, you can request an increase online. Some rules of thumb are that you’ve been a cardholder for at least six months, you’ve paid your card off every month, and you haven’t requested a credit increase in the past six months. You can also try to call your credit card company and explain why you’d like a credit increase.

Alternatively, you can also adjust your income in your card settings and see if you’re granted an increase based on that information.

A credit card company might also grant you an increase based on years of paying off your card on time or when you’ve had a significant income boost.

Though a higher credit limit does increase how much total credit you have, you still need to be mindful of how much you’re spending. Don’t increase your credit limit because you’re short on cash, as this can wreak havoc on your credit score in the long run.

This article originally appeared on GOBankingRates.com : 5 Questions To Ask About the Impact of Credit Limits on Your Finances