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Credit score formulas not changing as credit limits slashed

Fair Isaac, VantageScore take wait-and-see approach to economic crisis

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Credit card issuers' recent decisions to trim credit limits has lowered millions of consumers' credit scores. But the companies that create credit scores say they feel no obligation to adjust their credit scoring formulas to recognize the new credit landscape.

In recent months, major credit card issuers have sharply lowered limits on credit cards in an effort to stem the losses inflicted by sharp cardholder delinquencies. A Nov. 3, 2008, Federal Reserve survey of senior loan officers showed that about 20 percent of banks had reduced consumers' existing credit card limits for prime borrowers, while about 60 percent reduced limits on nonprime borrowers. A Federal Deposit Insurance Corp. report says those reductions in credit limits -- by cutting or closing consumers' credit card accounts -- totaled $123 billion in the third quarter of 2008.

Credit cardholders, even those who consistently pay their card bills on time, have as a result seen credit scores lowered.

Lowering credit limits automatically reduces many consumers' credit scores because it changes a key ratio that Fair Isaac Corp. and VantageScore -- the chief suppliers of credit scores -- use in calculating scores. In the credit scoring formulas, having a high amount of unused credit says you're a responsible borrower. Having a high amount of unused credit is rewarded with a higher credit score. Lowering that ratio lowers credit scores.

A revised version of Fair Isaac's credit scoring formula has been in the works for some time but is finally set for use by the three major credit bureaus starting in 2009. However, it likely won't do anything to address the problems of those whose scores have been hurt by slashed credit limits. According to Fair Isaac spokesman Craig Watts, the new formula will make "subtle changes" to the way FICO scores assess credit risk, but Watts says that none of the changes will alter how consumers can improve their credit scores. In other words, borrowers who have their credit limits slashed probably shouldn't expect a reprieve at the hands of Fair Isaac, even though a Dec. 18, 2008, press release underscores the significance of the issue, saying, "If your credit card balances are close to your credit limits, budget your finances to make debt reduction a top priority. Your indebtedness is the second-most important factor for FICO scores."

Credit line reductions may come as a surprise to cardholders, regardless of whether they find out about them from a bank letter or a penalty charge. "Some know when they get the notice, and some know when they get the over-the-limit fees," says Gail Hillebrand, spokeswoman for consumer advocacy group Consumers Union, noting that some consumers are seeing credit limits reduced to the amounts they owe their lenders.

Even cardholders who maintain balances below their new credit limits may suffer. Since part of the mathematical formula used to calculate a borrower's credit score -- which helps lenders determine whether to give a potential borrower money and at what interest rate -- depends on the ratio of how much credit a borrower has access to versus how much the consumer is using, lowered limits could trigger higher borrowing costs.

Fair Isaac and VantageScore acknowledge this fact. However, when it comes to lowered limits, Fair Isaac's Watts says that although data (rather than more subjective factors) drives any changes to its scoring model, the company will "continue to analyze this industry activity and any potential impact on FICO scores going forward." VantageScore has a similar response. "At VantageScore, we regularly examine our model to see the effect that changing economic and environmental conditions play in the determination of consumer scores," VantageScore Solutions President and CEO Barrett Burns says in a statement. Fair Isaac is the creator of the popular FICO credit score, while VantageScore is a joint venture between three major credit bureaus: Equifax, Experian and TransUnion.

Credit scores are still a bit of a black box.

-- Gail Hillebrand   
Consumers Union spokeswoman   

Nobody move and nobody gets hurt
Fair Isaac and VantageScore say that lowered credit limits are unlikely to hurt the bulk of borrowers. According to Watts, Fair Isaac's ongoing research "shows that lenders have reduced the credit limits for revolving accounts for a relatively small population, and those line reductions have been a relatively small amount for a sizeable part of that population." VantageScore's Burns also downplays the lowered limits. "While utilization accounts for a part of each consumer's credit score, there are multiple consumer behaviors that contribute to a credit score, with payment history remaining as the largest contributing factor," he says via a statement.

Consumer Union's Hillebrand disagrees. "It's always a little misleading to say it's only going to affect a small number of people," she says. "The overall statistics could mask the real harm to individual households." Banks contacted for this story were largely unwilling to comment, although Bank of America indicated that FICO is just one of many factors it considers when making lending decisions.

For Hillebrand, the harm comes from the way a jump in utilization rates could translate into steeper borrowing costs. She notes that consumers who have spoken with her organization are reporting sizable cuts to their credit limits, in some cases amounting to a 40 percent or 50 percent reduction from their earlier lines of credit. That means consumers using 30 percent of a credit line may quickly find themselves with a new utilization rate of 60 percent. "If it happens to you, it's going to hurt you," Hillebrand says.

Other factors are important 
How badly it hurts varies. "FICO scores assess a wide variety of data on credit reports, so the impact to the score by a single factor like credit limit reductions will depend on what other data is on the credit report and the amount of the credit line reduction," says Watts. "The person's score could be unchanged, it could go down or in some cases it could go up." That's because a borrower's credit utilization doesn't exist in a scoring vacuum. "Just reducing credit limits by themselves, or raising credit limits, for that matter, has no impact on credit scores," Watts says.

VantageScore's Burns echoes those thoughts. "The effect of each of these factors on individuals' credit scores varies based on the consumers' unique debt management behaviors. This means that the reduction of a credit line does not impact individual scores in the same manner with every consumer. The majority of consumers could see very little impact, while others may see more change," Burns says. "There are too many variables to provide definitive answers to hypothetical questions regarding factors, including reduced credit limits, that might affect a consumer's credit score," he says.

The difficulty is knowing how those factors combine to move a credit score in one direction or the other. "Credit scores are still a bit of a black box," Hillebrand says, adding that many consumers are potentially still largely unaware of how credit limits play into the calculation of credit scores. Even for consumer advocates, the impact on a credit score is difficult to decipher. Ed Mierzwinski, consumer program director for U.S. PIRG, agrees that while the lowering of a credit limit increases the borrower's utilization of available credit, "The question is how much. The high priests of the secretive Fair Isaac cult usually don't spring for such details," he says.

Fair Isaac can't say exactly how utilization ratios impact individuals. While the "amounts owed" portion of the credit score model accounts for 30 percent of an average borrower's score, individual actual results may vary. That weighting "may be considerably higher than 30 percent for some consumers and considerably lower for some consumers," Watts says.  

It doesn't matter if their score was low or high to start with. It matters whether they carry high balances on that or other accounts. 

-- Craig Watts    
Fair Isaac spokesman

Low-risk borrowers more likely to suffer
The move to cut credit limits may have the greatest impact on the credit scores of higher-quality cardholders who carry a balance on their credit cards. People who have good credit scores "are more likely to experience a deterioration in their credit score due to a drop in limits," Hillebrand says. That's because what could amount to just another minor negative for consumers with really poor scores could be more a more damaging black mark on generally clean credit histories, she explains. Fair Isaac's Watts modifies this somewhat, noting that bad credit histories may put some borrowers' closer to lowest possible FICO scores, while those lower-risk cardholders' high credit scores have more room to fall.

Fair Isaac says the impact is more about whether cardholders are revolvers than if they have a high or low credit score. "The population most at risk is going to be that population that carries a high balance," Watts says. "It doesn't matter if their score was low or high to start with. It matters whether they carry high balances on that or other accounts." The history of a borrower's limit on one credit account is irrelevant, Watts says, since Fair Isaac's model is a snapshot of overall credit usage and doesn't consider if individual credit lines have been altered.

Take action
While cardholders can't do much to prevent their credit limits from coming down, there are steps they can take to protect themselves.

  • Pay down debt. By paying off debt, which reduces their use of credit, borrowers can re-balance their credit utilization ratios. "In general, you want your ratios as low as possible, and definitely less than 50 percent," U.S. PIRG's Mierzwinski says. Fair Isaac's Watts concurs with that approach. "If you have low balances going into it, it's not going to be a big deal. If you have high balances, pay down those balances," he says. 
  • View your credit report. Because changes to a credit limits can affect consumers differently, it's important for borrowers to consider their situations as spelled out in the explanations that accompany credit scores. "Pay attention to what's holding your particular score back" and work to correct the problem, Watts says. "If the explanation says nothing about high balances, then you don't need to worry about that."
  • Opt out. If higher interest rates do follow a lowered credit score, cardholders should ask their issuer about opting out -- paying off their balances at the current APRs. Cardholders who opt out will be unable to continue making purchases with their card.(Update: On Aug. 20, 2009, provisions of the Credit Card Act of 2009 went into effect that mandated consumers be given the right to opt out of increases in interest rates, fees, finance charges and certain other changes in credit card agreements. See story.)
  • Practice good borrowing habits. Even if limits change, responsible behavior shouldn't. "To maintain a good VantageScore or to improve it over time, we encourage prudent borrowing in relation to a borrower's ability to keep payments current; applying for credit only when it's needed; not opening new accounts frequently or opening multiple accounts within a short time span; and paying any delinquent accounts as soon as possible, then keeping them current," Burns says.   

Outside assistance
Cardholders could get some relief from  new credit card regulations approved Dec. 18 by federal banking regulators. The rules prevent issuers from boosting interest rates on money that has already been borrowed, even if the cardholder's credit score falls. However, the rules don't take effect until July 2010.

Other relief could come from a less likely source: the banks themselves. Hillebrand says banks could step up and acknowledge that "we caused this problem, and we're not going to ding you for it," she says. Since a bank could conceivably lower a cardholder's credit limit -- thereby reducing his or her credit score -- and then turn around and boost the borrower's APR due to that very same drop in the credit score, banks themselves can offer a solution. "They could waive their universal default clauses when they cause the default," Hillebrand says. Under universal default, banks have the ability to hike cardholders' APRs based solely on their declining credit scores.

In the end, the currently unfolding situation may be less about credit limits and more about lending decisions that the banks are now trying to undo. "We are not saying high credit limits are a good thing," Hillebrand says. However, the decision to now lower credit limits is a result of overzealous lending that is now causing a spike in defaults. "Someone didn't do their homework on the front end," she says, "and that someone is the lender." 

See related: Fed report: Banks tighten lending standards even more, How to read, understand your credit report

Published: December 29, 2008


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