What should your credit limit be?
NEW YORK (CNNMoney.com) – Consumers know all too well that going over their credit limit can lead to nasty fees, a higher interest rate and possibly even a lower credit score.
But few people are aware that just approaching their limit can also have costly consequences.
Indeed, your debt ratio, or “debt utilization”, is a key component of your credit score. Your debt-to-limit ratio is calculated by dividing what you’ve spent by your total credit limit.
If you have a limit of $5,000 and you billed $4,000 this month, your debt-to-equity ratio is 80%, which is enough to signal to lenders that you are a high-risk borrower.
As a result, lenders may increase your annual percentage rate (APR) or deny you a loan, even if you pay off your credit card balance each month and have never gone over your limit.
About 14% of Americans use at least 50% of their available credit, according to Experian’s 2007 National Score Index study. However, experts recommend keeping your debt ratio below 30%, or even below 10% if possible.
This means that if your limit is $5,000, you should aim to charge less than $500 per month.
The lower your debt ratio, the better your credit rating will be. And to that end, there are two basic ways to improve your debt utilization: increase your credit limit or reduce your debt.
Increase your limit, reduce your debt
Your credit card limit is shown on your monthly bill, but may change from billing cycle to billing cycle. This is because credit card issuers can raise or lower your limit as they see fit.
But while credit card issuers generally dictate your limit, consumers have a say. You can call and ask for your limit to be increased, because the more credit you have available, the better your debt ratio will be.
“If you have a good credit history, your credit card issuer will raise your limit, but if your history isn’t great, they might say ‘No,’ which isn’t necessarily a bad thing,” according to Bill Hardekopf, CEO of LowCards.com.
“Getting denied a higher credit limit can be a blessing in disguise,” Hardekopf said. Chances are, this is a signal that you should cut back on spending or pay off your credit card balances instead.
When repaying debt, it is important to consider that your debt usage is calculated per card and cumulatively. This means that leaving one card nearly depleted will undo all the hard work you’ve put into paying off balances on other cards.
And a higher limit is not always better. “If you are a spendthrift and the temptation is to spend more than you can really afford, [then a higher credit card limit] can send you into a spiral of debt,” Hardekopf said.
It’s also possible that potential lenders may view an exorbitant credit limit as potential debt, which can work against you if you’re trying to get a mortgage or car loan.
Ultimately, “it comes down to how you manage debt. If you manage debt responsibly, go for a higher limit,” said Greg McBride, senior financial analyst at Bankrate.com. But, consider if “this higher credit limit is going to represent the temptation to take on more debt.”
Ideally, you want to illustrate that you can keep your spending under control, which means “you should focus on paying down debt, not accumulating it,” McBride said.
Pitfalls to avoid
According to experts, subscribing to new cards to increase your total available credit and make your debt utilization appear lower can work against you. In fact, opening new accounts can even lower your credit score.
“Recent credit inquiries make up 10% of your score,” McBride said. And each new request means potential points subtracted from your total.
Additionally, closing unused cards is also a bad idea.
“When you close an account, the amount of “overall” credit available decreases, which may cause your [debt] use and inadvertently lower your score,” said Deanna Templeton, director of consumer education for Credit.com.
Templeton also recommends periodically using old credit cards, just to prevent your issuer from closing them due to inactivity. “Once in a while, charge something small like gas or dinner and then pay it when you get the bill,” she said.
First published: September 25, 2008: 11:43 a.m. ET
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