What is the purpose of setting a credit limit?

Setting a credit limit primarily serves to manage risk for lenders. Credit limits are determined based on various factors, including the borrower’s credit history, income, and overall financial health. By establishing a limit, lenders can mitigate potential losses that could arise if a borrower defaults on a debt.

When a lender sets a credit limit, it assesses the maximum amount that can be extended without significantly increasing the risk of default. This also helps maintain the financial stability of the lending institution, as it allows them to control their exposure to individual borrowers and the overall market.

While providing unlimited access to credit may seem beneficial for consumers, it could lead to irresponsible borrowing and increased likelihood of defaults. Maximizing the amount of loans or encouraging spending among consumers without restraint would not align with prudent lending practices that prioritize long-term sustainability and risk management. Thus, the establishment of credit limits serves a critical function in balancing the interests of both lenders and borrowers, ensuring that credit is offered in a responsible and manageable manner.