We have been writing about how credit decisions are made over the past few days, in hope of giving you a better understanding of why disparities in credit terms and limits show up between two people when they seem to have a similar credit profile on the surface. Today we are going to discuss a widely misunderstood issue regarding your credit score's relationship (or lack thereof) to your credit limits.
Scores vs. amounts
First, it's important to understand that your credit score is a performance score which is based on factors in your credit report that can be objectively evaluated as to how well you manage your credit and pay your bills on time. Most FICO credit scoring models place your score in the range of 300-850, although some industry specific scoring models will extend outside that range. You could just as easily reduce this amount to a percentage on the scale from 0-100%, since there is a clear defined upper limit.
Credit limits are open-ended amounts that will vary based on factors not directly related to your credit performance, such as income, cost-of-living, geographic area, the economy, how aggressively you pursue limit increases and other factors. As you begin to build credit when you are starting out, banks will generally assign conservative limits regardless of your income. The bank rationalizes that even though a starter limit will be less meaningful to some individuals than others, the bank must protect itself with an unknown credit risk and therefore starter credit limits aren't directly proportional to your income.
How does my credit limit increase?
If credit limits aren't dependent on scores and vice-versa, how does one attain large credit limits? It is a process of stair-stepping over time. With careful strategic management of your credit, you can quickly gain your lenders trust and increase your credit limits. Keeping your balances low, using your credit wisely, and paying on time usually results in surprise credit line increases.
Conservative credit management may keep limits low
Here's a catch though, and where many people get tripped up: for whatever reason, credit card issuers usually place you into an internal tier upon approval and it's usually hard to move too far outside the predetermined range. This can have the effect of placing users who manage their credit conservatively and don't shop around for credit at a distinct disadvantage as compared to users who take advantage of new offers and "play the credit game". Even obtaining a new card from the same issuer may eliminate the ceiling and give you the opportunity to continue to increase your credit limit.
What about my income?
You may be wondering why a high score wouldn't prompt a lender to automatically give you the largest limit based on your income. Banks have found that it's wise to be cautious in granting credit to users who aren't used to managing large amounts of credit, and gradually increase credit limits over time.
Why can't lenders index credit limits to credit scores?
Because it would be incredibly discriminatory to many classes of people. Imagine the following scenario:
- Lender is required by law to index credit limits on new accounts to the user's credit score. The lender sets up tiers, similar to interest rate tiers used on new accounts, that must be applied to all new accounts fairly.
- User A in Washington, DC with a credit score of 750 applies for card and falls within tier B, qualifying them for a credit limit of 10% of their stated annual income of $120,000 which comes to $12,000.
- User B in Iowa with a credit score of 750 applies for a card and also falls within tier B, qualifying them for a credit limit of 10% of their stated annual income of $60,000 which also comes to $6,000.
- It all looks fine, right? Wrong. Because user A lives in Washington, DC, with a much higher cost of living and average income. User A spends more of their income on housing, transportation and bills, leaving roughly the same amount of disposable income as user B in Iowa, but is granted twice the credit limit relative to disposable income.
- You may be thinking that we could adjust for this by factoring housing payment into the equation, but this isn't a perfect solution either. Then you have to account for users without a house payment who may be living with relatives, or users who are able to use their spouses income on the application while leaving the housing payment out, and a myriad of other never ending possibilities.
- Further regulation would ensue, and soon, banks would have to further restrict access to credit in order to adequately manage risk, denying lower income individuals access to credit at all.
This is why the most fair solution is to let everyone build individual credit capacity necessary for their spending needs and lifestyle by careful management of their own credit profile, which is the current method of building credit. The bottom line is that when you start to move the goal, you are simply replacing a perceived bias with actual bias, or a number of them.