Myth #6: Never accept a credit limit increase, it will damage your credit.
Reality: If you use your credit wisely, I credit limit increase can actually help to improve your credit score. Your credit score is determined by a complex algorithm that weighs your credit activity according to the following:
35% Paying accounts on time (minimum payment)
30% Credit utilization
15% Credit history
10% Number of inquiries (hard inquires)
10% Types of credit (diversity of credit also plays a small part)
If you are looking to increase or decrease your credit limit, your credit utilization will play a big part in this.
Simply put, ‘credit utilization’ looks at how much debt you owe on a credit product, against the credit limit you have on that product. The general rule of thumb is that the lower your credit utilization, the better your score. Because your credit score relies heavily on your credit utilization, holding a 30% weight, it’s good to explore this a bit further.
For example, if Person A has a credit card with a $5,000 credit limit, and they currently owe $1,000 on the card, their credit utilization would be 20% ($1,000/$5,000).
Now let’s say Person A was given an opportunity to increase their credit limit to $6,000, keeping in mind they still owe the same $1,000 on the card. Their credit utilization would now go down to 16.67% without actually reducing the principal of their $1,000 debt. Because their credit utilization is lower, their credit score should improve slightly. Credit score calculations are extremely complex, but the idea behind this example is what I hope to convey about the myth of increasing your credit limit.
We can also look at this example a different way. Using the same example of $1,000 debt on a credit card and a $5,000 credit limit, let’s say Person A now want to reduce the limit on their credit product to $4,000. Their credit utilization will now increase to 25% ($1,000/$4,000), even though they owe the same amount of debt of $1,000.
I have to make a big disclaimer here. I am not encouraging anyone to take on additional credit just to increase their credit score. However, I believe that being a good consumer, saver and investor is being well informed and having as much information as possible. I know when I first learned this information, it did not change my outlook on debt and credit other than being more aware of what credit products I open or close and whether or not I accept or not accept a credit limit increase.
Of course one can face series financial difficulty if they continue to accept credit limit increases without the means or the discipline to pay the minimum payments (hopefully more than the minimum payment) on time at the end of each month. Being extended more credit means more responsibility to manage the temptation of using credit and being sure to use it wisely.
My ultimate goal since becoming debt free is to strive to continually have a 0% credit utilization at the end of each month (billing cycle). Essentially, my husband and I strive to pay off our credit products in full (credit card and unsecured line of credit) at the end of each month. So far we have managed to do this and we are really grateful for that. If one can pay off their credit cards in full at the end of each billing cycle, then the credit utilization weighting becomes a non-issue. With a credit utilization of 0%, it does not matter whether your credit limit is $1,000 or $10,000 where credit utilization is concerned.
Solution: Only accept the credit limit that you feel comfortable managing on a month to month basis. If you struggle with making your payments on time and have poor history of managing credit, a credit limit increase would only make the problem worse. Accept only the credit limit you feel comfortable managing and strive to have your credit utilization at 0%. However, keeping your credit utilization low at 30% or less is a good goal to aim for.
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