Lower credit limits can hurt consumers' credit scores
Newly cautious card issuers cut available credit, changing key ratio
By Dana Dratch
The latest victim of the lending crisis could be your credit score.
Even if you haven't been directly affected by subprime mortgage problems, your score could take a hit. That's because new research says a majority of credit card lenders are lowering credit limits to reduce their risk in the wake of the credit crunch.
When a customer's available credit goes down, for any reason, it brings the current balance closer to the limit. That can lower the consumer's credit score substantially.
Why? A key component of credit score calculations is the ratio of used credit to available credit -- the "utilization ratio." About 44 percent of cardholders carry a balance at least occasionally. For them, any reduction in credit limit lowers the ratio, lowering their credit scores.
"It's quite an issue," says Linda Sherry, director of national priorities for Consumer Action. When the organization conducted a recent online poll, 11 percent of participants reported they'd had credit limits lowered in the past six months. "It shows us that something is definitely going on out there."
Banks cut risk, hoard cash
"I think what we're seeing now is a lot of banks, big and small, are entering into capital preservation mode," says Peter Garuccio, director of public relations for the American Bankers Association.
A July 30, 2008, report by Javelin Strategy & Research says that of the 13 top-tier credit card issuers it surveyed, eight said that as a direct result of current economic conditions, they had reduced consumers' credit lines.
It's a move took Jerry Jacobs by surprise. About eight months ago, one credit card bank reduced his $10,000 limit to $6,200, just above his card balance. The Florida resident says he's never missed a payment or been late with a bill, and his phone calls to the company netted no real reason for the change.
"They said, 'It's just a random thing we do -- it's not directed at you,'" he recalls. Regardless, his card was suddenly maxed out and useless.
The same thing happened to Orange County, Calif., resident James O'Neill. With a $16,000 limit, a $3,200 balance, and a perfect payment history, he was satisfied with his credit situation. But then one company lowered O'Neill's limit to $3,400.
That made him so mad, he promptly paid off the card. Now he uses it only occasionally for small purchases, just to keep the account active. "I don't want to pay them any interest," says O'Neill. "I hate them."
With the FICO score, the most widely used credit scoring model, the ratio of used credit to available credit counts for "almost a third of your score, so it's significant," says Barry Paperno, manager of consumer operations for Fair Isaac Corp., the company that pioneered credit scoring and formulated the FICO score.
With the alternative credit score VantageScore, credit utilization accounts for 23 percent of the score, according to Wayne Travers, vice president of media relations for VantageScore Solutions LLC.
With the FICO-based scores, it's best to keep balances below 50 percent of the limit, says Paperno. "But 40 is better than 50, and 30 is better than 40," he says. "The lower that utilization number is, the better it is for your score," says Paperno.
But some believe that even 50 percent is too high to maintain a good score. "You need to stay at 30 percent or below," says Gail Cunningham, spokeswoman for the National Foundation for Credit Counseling.
So how much could a credit reduction hurt your score? A lot of that depends on what your credit report looks like in the first place. It will likely have more of an impact on someone who has a short credit history or only a couple of credit accounts, says Paperno.
You could also drop faster if you have a higher score, he says.
FICO scores run from 300 (worst) to 850 (best), and the average is around 720, says Paperno. If your score is 750 to 800, taking a card from 10 percent utilization to 100 percent could drop your score 90 to 140 points, he says. If you're at 700 to 749, it could drop it 50 to 100 points. And if your score falls in the 650 to 700 range, it could drop 40 to 90 points.
"If you had one credit card, you could go from 810 to 640 overnight," he says.
And if other lenders follow suit, raising your rates or lowering limits on other cards, "it could be devastating," says Paperno. (See related story, What to do if a card issuer cuts your credit limit.)
For anyone reading the headlines, "it's clear we're in an economic environment that's quite challenging," says Lynne Strang, vice president of the American Financial Services Association, a member group of credit lenders. As a result, there's "an effort on the part of all creditors to scrutinize closely their borrowers," she says.
Credit lenders are lowering limits to reduce their risk, and "it's really being done on a case-by-case basis," says Strang.
Lender, heal thyself
What really worries consumer advocates is that credit lenders may be doing this more in response to their own missteps than those of customers.
"Did the consumer become more risky just because their credit card lender decided to reduce their exposure?" asks Chi Chi Wu, staff attorney for the National Consumer Law Center.
Even if you've done nothing wrong, it "can end up costing you a fortune," especially if you're contemplating a mortgage or car loan, says Joe Ridout, spokesman for Consumer Action.
If you have a number of cards, the actions of one could, potentially, trigger a domino effect of lower limits, falling credit scores, and higher interest rates.
There's "nothing new about credit card lenders reviewing customer accounts and raising or lowering limits," says Garuccio. Currently, "economic pressure is certainly influencing bank behavior."
Lowering limits could be the best of several bad alternatives.
"It's better for them to reduce the limit than to triple the interest rate," says Wu. "The credit score is a flexible number. It can recover."
When the credit limit decreases with the balance
One new twist for consumers and consumer advocates: Some credit card lenders are reducing the limit more than once, each time to just above the balance. So while cardholders are actually paying down their debts, the accounts are consistently reported as "maxed out" to the credit bureaus.
"It has the effect, on paper, of making you look less attractive" as a borrower, says Ridout.
A few months after one bank cut his limit to $6,200, Jacobs had paid the card balance to about $4,000. Then he got a letter from the company, stating that it was again reducing his limit to just above the current balance. As a result, he's not using plastic at all. "It cuts you back," Jacobs says.
And the practice is becoming more common, says Ed Mierzwinski, consumer program director for the U.S. Public Interest Research Group. "We're getting more and more complaints about banks ratcheting down limits as consumers pay down the balance," he says.
What can we learn from this?
Often, according to consumer advocates, customers are blindsided by the announcement that their credit limits have been lowered. "So many times it seems to be falling on people with perfect payment histories," says Ridout. "The frightening thing is that consumers who seem to have dotted all the i's seem to be in line for credit limit decreases."
The move, by credit card banks, has also revealed flaws in the nation's personal finance habits, says Wu. "Part of the problem is that people have been staying afloat on credit, and that's not a good thing."
The miracle of instant credit is now, in some ways, becoming a curse.
|-- Evan Hendricks
Others believe creditors are at least partly responsible.
"The miracle of instant credit is now, in some ways, becoming a curse," says Evan Hendricks, author of "Credit Scores & Credit Reports: How the System Really Works, What You Can Do" and publisher of Privacy Times. "They got consumers hooked on it, and are now taking it away."
In the long run, lower credit limits could have a welcome consequence for consumers: Going cold turkey is a great way to kick the revolving balance habit.
"All of this may be the best thing that ever happened to us," says Cunningham. "We should be paying off the bill when it arrives."
Dana Dratch is an Atlanta-based writer who covers finance and lifestyle issues for national publications.
See related: What to do if a card issuer cuts your credit limit
Updated: August 18, 2009