The seemingly arbitrary way a credit card company decides your credit limit is actually a result of considerable testing and analysis. Underwriting is the process by which credit card companies determine who to approve, at what rate, and at what credit limit. Underwriting guidelines are guarded company secrets because they can significantly impact the profitability of a credit card portfolio. There is little transparency around the credit card industry regarding underwriting requirements, and limited understanding in consumers' impression of how credit limits are determined.
To shed some light on the practice, Credit Karma sampled over 500,000 credit card accounts in June 2009 and compared average user credit limits with their credit scores. This graph below shows a correlation of consumers with a higher credit score having higher credit limits.
The connection of higher credit score and higher credit limit becomes crystal clear when we consider the purpose of credit card underwriting. A cardholder's credit score can, among other details, indicate their risk of defaulting, history of on-time payments, and good (or not-so-good) overall credit management. Using a consumer's credit score, a credit card company can calculate the consumer's expected default rate at any time to help determine whether an increase in the cardholder's credit limit could provide an additional revenue opportunity, or whether a credit line reduction is necessary to reduce risk of losses.
For example, a consumer with a fair credit score may have a $1,000 credit limit with an expected default rate of 10%, making the expected loss approximately $100 (Default rate 10% X Credit limit $1,000). A consumer with an excellent credit score may have a higher $10,000 credit limit with an expected default rate of 1%, making the expected loss approximately $100 as well.
In this scenario, with expected losses being equal, the excellent credit score cardholder is provided a higher credit limit, thanks to their better credit profile with lower default rate, enabling the credit card company the potential for greater profits through credit card purchases, fees, and interest. Not surprisingly, as credit card companies reassess their portfolios, they are continually looking for opportunity to manage their losses whether that is with credit line increases or reductions.
In fact, the spread of underwriting guidelines amongst different credit card companies diversely affects how each issuer sets their cardholders' credit limits. Based on Credit Karma data on the top 5 credit card issuers, Bank of America had the highest average credit limit at $11,288, whereas Capital One had the lowest average credit limit at $3,254. This may be best explained by the difference in the types of consumers they target and their corresponding marketing approaches. Bank of America tends to leverage banking customer relationships by focusing on customers with higher credit scores, which accounts for the greater concentration of high credit limits. On the other hand, Capital One captures a larger segment of the credit spectrum by taking a chance on marginal credit consumers with lower credit scores, which accounts for the concentration of smaller credit lines.
The influence of credit score on credit limit works in a feedback loop: credit score influences credit limit, and a consumer' s total credit available, which is the sum of their credit limits, can impact a credit score up or down. But the relationship between credit limit and credit score is not mutually exclusive. Other factors such as credit utilization, payment history, other lines of credit, changes in spending patterns, and household income can contribute to an increase or decrease in consumers' credit limits.
The bottom line is that underwriting frames the rules of the game when it comes to issuing credit and setting credit limits. But by better understanding how credit scores influence credit limits and vice versa, you can play the game to your advantage with a more empowered approach to managing your credit health.