What it is:
A credit limit is the maximum amount that a person may charge on a credit card or borrow from a financial institution.
How it works (Example):
After a financial institution has approved an applicant's request for a credit card or another type of revolving credit, the lender will decide on the maximum amount of credit it's willing to extend to that person; this maximum amount is known as the credit limit.
A credit limit is based on several factors that influence a borrower's ability to repay. Generally, the applicant's credit score, income and job stability are the main factors considered in determining an appropriate credit limit.
For example, let's assume you go to Bank ABC and apply for a credit card. After being approved, Bank ABC puts a credit limit of $10,000 on your new credit card after reviewing your credit score, income level and the length of time you've stayed at your current job. This means that you may potentially charge up to a $10,000 on the card.
Why it Matters:
Generally, you will be granted a larger credit limit if you have a larger income, stable job and good credit score. But if you exceed the credit limit on your card or loan, you may be charged penalties and fees by the bank, and you may have your credit limit reduced.
The credit limits on your existing credit cards and loans may change depending on the bank's circumstances or on your actions. For example, if you have consistently made payments on time, the bank may increase the credit limit on your current card because you are considered less risky of a borrower to loan more money to. However, your bank may also reduce your credit limit(s) if it considers you to be a risky borrower that may have trouble making credit card or loan payments.