Your character's level is a measure of the powers and abilities they have access to. Each level you have increases hit points, power points, and attack power, grants access to more skills, and may give a variety of benefits depending on the class chosen (the magnitude of the other leveling benefits also depends on the class chosen). Note that NPCs have an effective level (EL), which can give you a rough idea of how powerful they are relative to you (shopkeepers, for instance have an EL of around 20 making them practically impossible to take on at level 1).

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