What is a credit limit and does it matter?

If you are applying, or using, a credit card, you may wonder how much you are able to spend when using that card. This is called a credit limit. We take a look at what a credit limit is and what it means.

What is a credit limit?

A ‘credit limit’ is the maximum amount of money a lender will loan to you via one of their credit products. The term is widely used across the financial product market and can apply to all different kinds of loans, such as home, car, personal or margin loans and credit cards.

What’s a credit limit on credit cards?

When you take out a credit card, you are signing up for a loan from a financial institution. You are also agreeing that you will pay back that loan under certain conditions. Usually, credit cards are set up so that you are continually borrowing a portion of the loaned amount and paying it back according to a schedule, and you are charged interest depending on that repayment schedule.

The credit limit is the amount of credit (loaned money) you and the lender agree you will use on that card. But it’s important to know that this does not automatically mean that the card will stop working when its credit limit is reached. That depends on the loan agreement that you have with the financial institution. (Read more on that, below.)

Explore: How to get a credit card: Are you eligible?

How does a credit limit on a credit card work?

A financial institution may offer credit card products with different credit limits, such as a $10,000, $20,000 or $50,000 credit limit.

Let’s say someone chose a card with a $10,000 credit limit. This means that the total amount of money that person can borrow using that credit card would be $10,000 in total.

That person would apply for the credit card and the financial institution would evaluate their application and decide whether or not to issue the card and the credit limit to the applicant, considering factors such as their credit score. If the application was successful, that person would receive the credit card (or a virtual version of it) and be able to use it to borrow up to $10,000 for purchases.

A hypothetical example to explain how it could work is below:

Joe is approved for a credit card with a credit limit of $10,000. He is able to track his spending on that card via his bank’s mobile phone app. He is going to use the card to buy items for his home office renovation.

Before Joe starts using the credit card, he checks his banking app. The balance summary for the credit card on his app reads:

• Balance: $0
• Available: $10,000

On Monday, he buys a computer worth $3,000 using the card. The balance summary for the credit card on his app reads:

• Balance: -$3,000
• Available: $7,000

On Tuesday, he purchases a $1,000 desk, and a $4,000 couch. Balance summary:

• Balance: -$8,000
• Available: $2,000

On Wednesday, he pays $2,000 off his credit card as he knows he needs extra funds on the card to buy other items. Balance summary:

• Balance: -$6,000
• Available: $4,000

On Thursday, he buys a podcast production system worth $4,000. Balance summary:

• Balance: -$10,000
• Available: $0

Fees and charges would also apply, as based on the credit card terms and conditions, and be reflected in the statement progressively.

With $0 available on his credit card, whether or not Joe can continue making any further transactions – and exceed his credit limit – would depend on the particular policy he has taken out with a lender, and the terms and conditions that apply to his credit contract.

Explore further: Pros & cons of using a credit card

Can you go over your credit card credit limit?

Whether or not you can spend more than your credit limit on your credit card depends on the credit agreement you have with your financial institution. It’s a wise idea to find out what the financial institution’s rules are for ‘over-the-limit’ spending before signing up for a credit card.

Some agreements do automatically prevent transactions being made once the credit limit has been reached. In this case, purchases could be declined once a user has spent up to their allowable limit.

Some financial institutions allow credit card holders to ask that they not be allowed to exceed their credit limit, to help them to control their debt levels. Other financial institutions will only allow certain eligible cardholders to exceed their limit, such as those with a strong credit history.

If you do spend over your credit card’s credit limit, you may be charged a fee or have to pay extra interest, but this comes down to the policy you have taken out with a financial institution.

Not all banks charge ‘over-the-limit’ (also called overlimit) fees. But any purchase made via a credit card is added to the balance of the card, which means you still have to pay it back within a certain amount of time, typically with interest.

Even if you don’t plan on spending more than your credit card limit, fees and charges could lead to your account becoming overdrawn. Your personal credit rating may be negatively affected if you don’t make regular repayments on your credit card.

Explore: Beginners guide to using a credit card

Why does your credit limit matter?

Credit limits on credit cards are important because they can determine the following:

1. How much you can spend

As the credit limit on a credit card is the maximum amount you will be able to loan on that card, credit limits determine how much money you will have at your disposal to make purchases.

Compared to other types of loans, credit cards are typically more flexible in terms of when you can spend the funds and what you can spend it on.

For example, credit cards typically allow you to borrow a succession of small or larger sums, and use them to buy whatever you need (providing the seller accepts the type of credit card that you have). Whereas if you take out a car loan, for example, you have to use the loan for a car.

Keep in mind, though, that money borrowed on a credit card has to be paid back under strict conditions, and typically attracts a higher interest rate for unpaid balances than some other forms of credit.

2. How much debt you want

The credit limit is the amount of money you can loan from the financial institution. If you have a high credit limit, you will be able to borrow up to that amount and pay it back in instalments, with interest if certain conditions are not met.

If you want to try and minimise your debt levels, having a high credit limit could be an unwelcome temptation to spend more and therefore raise your debt levels. But if you opt for a lower credit limit, that may help you to control your spending.

Keep in mind that fees and charges, including interest, usually apply when using a credit card, and these can accumulate over time.

Developing a budget and learning how to manage expenses effectively can be helpful in minimising overall debt, and you could even consider saving up and creating an emergency fund, instead of relying on credit.

Learn more: Free financial advice: Where to find it

3. Your credit rating

How much you have borrowed – or have applied to borrow – will be listed on your credit report, which financial institutions and other parties may check. This includes information about credit cards, and what credit limits those cards have in total.

The total credit limit, regardless of how much of that credit you have used, will be considered when calculating your credit score.

For example, you could have multiple credit cards with different banks. Your debt level will be calculated by adding up the credit limits of all of your credit cards.

Your repayment history is considered, too. Why does this matter? Banks will check your credit score whenever you apply to borrow money, and your credit score could impact other applications, such as for rental properties. You can check your credit score for free with Canstar.

Explore further: Do multiple loan applications affect my credit rating?

If you are considering a credit card, it is important to read policy documents, such as the Target Market Determination and Key Facts Sheet that apply, to support your decision making.

Originally by Amanda Horswill, updated by Ann Lund
Cover image source: Nattakorn_Maneerat/Shutterstock.com