Credit Card Spending Limit, Credit Scores and Conventional Mortgages

by David Ning · 16 comments

reduce your credit card limit to borrow more money

My credit card company told me today that the credit bureau actually treat our credit card limit as debt when they calculate our debt-to-income ratio. It doesn’t matter whether we spend $30 or $3000 if our credit limit is $5000 because they just put $5000 as debt when they look at your credit because it is believed that since credit card is discretionary spending, it can be used in an instant so the worst case scenario is used.

This was very surprising to me but very beneficial because the lady over the phone also explained that if I were to apply for a mortgage, I should decrease all the credit card limits to make sure that I get the loan qualified. (Yes I was surprised that a credit card customer service agent was actually helpful, not to mention that I could perfectly understand this lady’s English).

Let me provide a theoretical example: Conventional loan financing are typically 28/36. This means for an individual to qualify for this type of loan, a maximum of 28% of monthly income can go to housing expense, and 36% of monthly income can go to housing expense and debt repayment.

Someone who makes $48,000 and have credit limits of $10,000 each on 2 different credit cards and no other debt:

$48,000 / 12 = $4,000 monthly income
$4,000 x 0.28 = $1,120 can go to housing expenses
$4,000 x 0.36 = $1,440 can go to housing expenses + paying off debt

With $20,000 credit card, the theoretical minimum payment is $20,000 * 0.025 (2.5% is typical and rough calculation for minimum payment) = $500. So instead of letting you borrow as much as $1,120 per month for your mortgage, you can only borrow $940 to still be qualified as a conventional loan.

What’s the difference of $180? With a 30-year fixed mortgage at 7%, $180 works out to be around $27,000. Quite a bit of borrowing power.

If we increase the debt repayment portion to be 2 x minimum payment (as suggested by some), the difference would be $680 and the borrowing power might be reduced as much as $102,000.

What Do You Think?
After doing the calculation, $100,000 seems like a huge difference when considering all the difference was asking the credit card company to lower the credit card limit. What do you think? Have you heard of anything like that? Would you believe the lady on the phone?

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{ 16 comments… read them below or add one }

Sandy November 5, 2008 at 11:24 am

$100k is a huge difference but with the lack of consideration of risk these days, I gotta say that the lower the loan limits, the better for everyone.

Sometimes you just cannot trust people to be responsible given the power.

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Thankful November 5, 2008 at 11:30 am

Was she specifically referring to FICO score, or just the credit score assigned by one of the three bureaus?

I don’t know that I’d believe that she was 100% correct, it’s hard to know without what she exactly said. I know for a fact that when we got our mortgage last year that the lender was not considering our credit limit to be debt when it came to debt-to-income ratio, and our scores improved once we had paid off a portion of the balances we were carrying (done to help get a better rate on the mortgage). Our credit limits are significantly higher than our gross annual combined salaries, so if that were true, I doubt anyone would have given us a loan. I think reducing a credit line would not help in qualifying for new loans.

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Mizé November 5, 2008 at 12:37 pm

Hello.
Here in Portugal works the same way, even if you have a small TV credit, it´s all registered in Portuguese Central Bank. Credit cards limits is what counts. When we need to aply for a credit, everything´s registered and all banks have access to this info.
Thanks for returning my drops. I don´t comment more often because I just don´t know what to say, lol. I enjoy reading your very informative posts.
Cheers.

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Philip November 5, 2008 at 12:58 pm

When I just got my mortgage (this year) they asked for my balance, but never considered my limits, and looking at the credit report it is only concerned with balance also.

If they do take that info into account I would check with another broker.

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Crisis Cartoon November 5, 2008 at 12:00 pm

I think there is no hard and fast rule on calculating the credit scores as each card companies varies from one another.

Just like a mortgage loan, different banks have different guidelines on the loan to income ratio and this guidelines are usually set internal. They are not transparent to the public and the issuing bank have to right to alter the rule whenever they deem manageable.

Ren

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Michael James November 5, 2008 at 2:34 pm

I’m with Sandy on this one. It’s best not to use all of your “borrowing power”. I find that eliminating debt gives me more of a feeling of power.

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MoneyMateKate November 5, 2008 at 5:45 pm

I used to live in the UK, and they definitely took credit limits/availability as well as balances into consideration. I figured that, given the ease of getting a mortgage in this country until a few months ago, US banks didn’t have this criterion. I don’t think it’s a bad thing.

I remember another criterion too: the maximum they would lend is a multiple of your gross income (3-4x), though in 2000 they were starting to get fancy with Bayesian theories (to take in factors like job stability and likely progression…crazy-hard mathematics).

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Mike Huang November 5, 2008 at 4:46 pm

Hmmm…I don’t think this is true. The higher your credit limit is, the better, from what I’ve been told. It’s also posted online. If you have a $500 balance and your credit limit is high, the ratio is a lot lower, so your score is higher and better. Of course having no balance is even better :D

-Mike

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marci November 6, 2008 at 9:22 am

Didn’t affect my credit score nor my score for new car insurance.

But as I haven’t applied for any loans, (nor intend to apply), nor have a mortgage, I have no clue how that is working these days.

Interesting thought.

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Elizabeth November 6, 2008 at 9:48 am

I don’t think your customer rep was correct. Between my husband and I, we have no less than a dozen credit cards. I use three of mine on a daily basis as I pay for everything with a credit card. My husband does the same thing except he tends to spread his purchases out onto 6 or 7 cards. My credit limit alone is $60,000 and three of my cards are fairly new accounts (two less than 1 year old). My husband is 30 years older than I am and has had some of his cards longer than I’ve been alive. I can’t even imagine what his total credit limit is.

For all that credit and all the charges we make, we carry no credit card debt. Each and every card gets paid off in full every billing cycle.

When we bought a house almost 6 years ago, we had absolutely no trouble qualifying for a loan. In fact, we qualified for over three times the house we ended up buying (we paid $225,000 for a solid but humble 2,300sf abode in the ‘burbs).

I don’t know exactly what our FICO score is but I know it’s excellent (I seem to remember it was in the 800’s. Is that possible?). In June of 07 we bought a new car and financed it because they were offering 1.9% financing for two years. We could have paid cash but at that interest rate, we actually earned money by taking the financing.

Anyway, my point is that I’d guess our total available credit exceeds our annual income still lenders tend to fall over themselves when we ask for credit.

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Kathryn November 6, 2008 at 1:27 pm

If the rep referred to FICO scores I think her advice is backwards as part of what is looked at is percentage of debt to available balance. If you lower your limit the debt:availability ratio increases thus decreasing your FICO score.

My recommendation? Save some cash and put down at least a 20% (you’ll avoid PMI) towards a fixed rate 15 year note. Good luck.

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Jon Kepler November 8, 2008 at 5:16 pm

Whether true or not, I’m fairly sure that this concept can be skewed or manipulated in other ways anyway. For instance, I’ve been told that American Express doesn’t report to certain agencies. Does Amex debt (or Amex credit) negatively affect you the way other credit card debt would? Maybe not.

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Miss M November 11, 2008 at 7:50 pm

I don’t think this is correct, at least in the US. It sounds like two separate things are getting jumbled together. Debt to income ratio applies to when you are getting a mortgage or loan. They only look at your actual debt to calculate it. Your looking at a girl who had a DTI of 60% when she bought her house, if you included my available credit it would be over 100% and I don’t think they would have given me the loan.

Obviously getting a home loan depends on how good your credit is, which is partly based on your balance to credit limit ratio. A $5 balance on a $5000 limit is better than a $4500 balance on a $5000 limit. When you get your credit score it includes the 4 reasons your score is not higher, which can be too high a balance to limit ratio, too much available credit etc. Make sense?

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Brenda December 29, 2008 at 12:53 pm

I don’t believe that the rep gave you the correct info at all. Maybe different lenders do things differently – especially nowadays. But from my research – with banks, mortgage lenders, financial experts, and even home-owners – I was told (since I am looking to buy my first home within a year) that you want your credit card limits to be over $10,000 each – if possible. Apparently that is some magic number… Anyway – they use the average of all of your credit card (the limit minus the average balance that you carry) to help determine if you have good credit.

One financial expert added that having many cards with over $10,000 as opposed to just a few MAY NOT (but it might) help you depending on how the lender calculates risk and credit. He said they may use the average limit of all cards and the average of all of your balances to determine your risk.

The same expert added that a student loan – in good standing – may help increase your chances of getting a loan and even the amount. He also added that car payments apparently are a very good thing – if you have a good payment history. They treat that debt differently (proving that you can pay off somthing similiar to a mortgage – responsibly) – and it can help you get future loans.

So as you can see – many, many different things apparently can help or hinder your getting a loan – and the amount of such.

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Liz June 8, 2009 at 12:06 pm

I don’t know that she was correct in claiming that the credit limit is viewed as debt. In fact, one very important factor in the calculation of your FICO score is your debt to credit limit ratio. So, it is generally not advised to ask for your limit to be reduced. However, you can get a low debt to credit limit ratio in two ways – either eliminate debt as much as possible (in which case it would be ‘safe’ to lower your limits… no balance with a low limit is still a 0% debt to limit ratio) OR keep a higher limit and don’t come close to it. Still, I have NEVER heard anyone advise people to lower their credit card limits and in fact there are a number of recent articles talking about the hit people’s FICO scores take when lenders choose to slash credit limits.

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Candice January 15, 2010 at 11:42 am

I know this is an old post, but I feel compelled to write this and tell you that your credit card company representative was a bit confused….and very wrong.

Your debt to limit ratio is comprised of your balances measured against your limits. The higher your limits and the lower your balances, the better your credit score will ultimately be (there are other factors, of course, that affect your score). In otherwords, lowering your credit card limits will HURT you when you go to apply for a mortgage.

Credit card companies are lowering credit limits left and right in an effort to minimize their losses during uncertain economic times. This sounds a bit like a dirty trick to me.

I beg you…PLEASE take this post down or modify it. People who need accurate information are likely to be led astray by this and end up damaging their own credit scores by adhering to one customer service representative’s misguided beliefs about how the credit system works.

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