Having high credit limits can sometimes seem like a validation of our financial success. If these lenders allow you to borrow such a large amount, they must think well enough of you and you are therefore you must be successful. For younger adults, it can even be fun competing with your friends to see who has the highest credit line. But beyond the fun and false beliefs, there are practical reasons why it can be good or bad to have higher credit limits.
Why It is Good to Have a High Credit Limit
If you have a long history of managing your finances responsibly, high credit limits have several advantages and they’re substantial.
Flexibility
If you have a revolving line of credit with a high limit, say $20,000, and you don’t have much of it outstanding, a high credit limit is a good thing to have. You can have the large, unused portion of the credit sitting there waiting for whatever purpose you might need it for. Even if you never do anything with it, just having it — and the options it opens up — is a good thing.
Better for Your Credit Score
Unused lines of credit can actually improve your credit scores. One of the factors that credit agencies use in determining your credit score is “credit utilization”.
What this is a measure of the ratio of outstanding debt to total credit limits. For example, if your credit limits on all of the revolving accounts total $10,000, and you have $9,000 outstanding on them, your credit utilization rate is 90% ($9,000 divided by $10,000).
Generally speaking, if your credit utilization rate is 80% or higher, it is considered a negative for your credit score. This means that you are getting close to your limits and could run the risk of not being able to pay back, or it is an indication that you have a habit of borrowing money to fund your lifestyle.
A low credit utilization rate is considered a positive and it will improve your credit score. This indicates that you manage credit responsibly and maintain a solid cushion. The lower this utilization rate is, the more positive the impact will be on your credit score.
A Backup Emergency Fund
Let me start out by saying that you should not rely on your credit as your primary emergency fund. If you use a credit line in this way, any emergency that you have will immediately put you into debt.
A savings account or money market fund should be your emergency fund. However, as we can never know the extent of any given emergency, it’s never a bad idea to have a backup emergency fund.
In this case, the unused portion of a high credit limit account can serve as a secondary emergency fund wherever necessary.
Money for Short-Term Investment or Business Needs
This is perhaps where a high credit limit can be most valuable. A high limit credit line can enable you to engage in short-term investments or to cover temporary business needs.
You never want to do this as a matter of course, but if you are waiting on a large bonus, commission check, or even tax refund, the high limit credit line will provide flexibility.
And Why It is Bad
If your track record in managing your finances is less than outstanding, high credit limits can pose a serious risk.
A Train Wreck Waiting to Happen
When you’ve had debt problems in the past a high limit credit line can be a constant temptation. It takes a certain amount of financial discipline to avoid being deep in debt, but if you have the large unused credit balance, it can be very easy to slip back into bad habits.
If you had debt problems in the past, you probably will want to keep your credit lines as low as possible just to avoid the chance that you might backslide.
Getting in Too Deep
If too much of the credit limit is outstanding as active debt, the high debt limit could turn against you. The higher limit, in combination with your own financial problems or lack of discipline, will be a recipe for disaster.
It’s one thing to have to pay off a $1,500 debt, but quite another if the amount outstanding is something like $15,000. High credit limit accounts make this situation possible.
It’s important to understand that just because the bank approves you for a high credit limit or a loan doesn’t mean that you can afford to borrow and pay back that money. Avoiding using something even close to the full credit limit takes discipline. If you don’t think that you have that, you would be much better off without the high limit credit lines.
When You Have No Savings
People usually manage their finances either out of their savings, or out of their credit accounts if they have no savings.
The second scenario is where high credit limit lines pose a serious threat. If you’re not a saver by nature, you’ll have no savings for emergencies, contingencies, or even large expenditures that are fully predictable.
That will almost certainly force you to tap your credit whenever there’s any need for money. That being the case, it will just be a matter of time before you will run up to the limit.
What are your thoughts on high credit limits? Good, bad, or somewhere in between?
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.
It can, of course, still be good to have a high limit if you are bad with credit. In that case, it’s best to get the credit card and stash it away in a drawer.