Understanding Credit Limits and How They Work

Dear Opening Credits,

So I just got my first credit card and I forgot to ask this question. You know how they set a limit for you? Well, mine is $800. Let's say I buy something that's $100. When I pay that $100 off, will the credit limit go back to $800?

- Cristina

Dear Cristina,

Isn't it lovely to hold your first ever credit card? Savor this moment. It means that you now have the liberty to borrow money from a credit issuer. You can buy stuff or services and enjoy them now, and then pay later.

To know how credit limits work, you've got to first understand billing cycles. This is the amount of time between monthly bills being due. By federal law, due dates must be the same date every month. During your billing cycle, you are allowed to charge any sum up to your credit limit.

So let's say that you did use your credit card to pay for $100 worth of items during a billing cycle. When the cycle ends, the issuer will send you a statement outlining where you used the card, how much you spent on each item, the total of what you spent (called the balance), and how much you are expected to pay as a minimum payment to keep the account in good standing.

If you were to send the issuer the entire balance of $100, you would not be charged any interest because you would have satisfied the debt within the fee-free grace period (which is your billing cycle). As soon as your payment is posted, your credit line bounces back to the full amount you're allowed to borrow. In your case, that's $800.

Easy and simple, right? Well, sort of. Calculations get a little more complicated when you pay less than the full debt. That because interest fees will be added to any amount you roll over to the following month, thus affecting your charging limit. For example:

Your credit limit is $800.
You charge $100.
You make a $30 payment.
$70 revolves onto next month's statement.
A $4 finance fee is added to the balance (assuming a 20% interest rate).
The total amount you can charge is $726 ($800 - $100 + $30 - $4 = $726).

It is important to always know how much you have spent with the card because you want to be sure that you can repay the entire debt by the time you get your statement. In the scenario I just described, a few bucks being added on doesn't seem like such a big deal. But if you ran the card up to the maximum and always just paid the minimum, it would take you 36 months to repay. The extra finance fees would be around $267 by the time you were at a zero balance.

Another consideration: from the date of issuance, all of your activity with this card is appearing on your consumer credit reports. If you use the card often, but pay on time and in full, you'll look like a credit goddess to all who view your file. However, let payments lapse or allow debt to escalate (constantly owing more than 30% of your limit is considered risky behavior), and you will quickly fall from grace. Keeping pristine credit will serve you well later on should you need to finance a large purchase, such as a car or a new home. Those with excellent credit qualify for the best interest rates.

The very best way to use that fresh, shiny card is to only charge what you can afford to repay in about 25 days. Do so and you'll not only have that $800 available to you, but the issuer may soon raise the limit, giving you even greater financial freedom. Can you handle the increase? Practice with this low line first and I bet you can.