Credit score suffers from being caught in 'balance chasing' loop
By Jeremy M. Simon | Published: April 13, 2010
Credit Score Report
Dear Credit Score Report,
Every time we make a substantial payment on a credit card, i.e. $1,000 or $2,000, our credit line has been reduced. This prevents our credit score from ever improving. How can you stop the "loop"? -- Alina
You are the victim of a recently developed, and none-too-friendly, credit card industry practice called "balance chasing." As soon as you make a payment and cut your balance, the issuer lowers your credit limit. That keeps a key credit scoring ratio -- how much of your credit you use -- in bad shape, preventing your score from rising.
Your situation is increasingly common, Alina, since many consumers are now paying for banks' excessive lending. "Credit card companies are making up for years of poor underwriting by drastically reducing credit limits on many of their accounts" says Lauren Bowne, staff attorney at San Francisco-based consumer rights group Consumers Union. She expressed hope that this is "a relatively short-term situation and things will level out eventually ... For now, just keep making your large payments and pay down your debt," Bowne says.
By continuing to pay down your debt, you're demonstrating the behavior of a responsible borrower. Payment history accounts for the biggest component -- 35 percent -- of your FICO score, the credit score most commonly used by lenders to decide whether to extend credit and at what interest rate. Over time, your record of on-time payments (along with other practices like keeping balances low and opening new accounts only when necessary) will help your credit score to rise.
Still, you are correct to be concerned about that "loop" of declining credit limits, since your balance-to-limit (or credit utilization) ratio is part of the "amounts owed" component of your FICO score. That category is the second most important portion of your FICO score, making up 30 percent of your score. However, unlike payment history, it's a category you have less power to control, because your bank is free to adjust your credit limit at will. Changes to credit limits can impact different borrowers' scores in different ways. "The impact for FICO scores of a reduced credit limit can vary depending on what else is on the person's credit report," says FICO spokesman Craig Watts, who recommends asking the bank directly why it continues to trim your limit.
Although the Credit CARD Act bans certain consumer unfriendly practices, this isn't one of them. "The Credit CARD Act does not contain any prohibitions against a credit card issuer lowering a consumer's credit limit, or even require the issuer to provide a written notice of the credit limit reduction," says Chi Chi Wu, staff attorney with the National Consumer Law Center. In some extreme examples, cardholders have even reported to us that their banks actually reduced their credit limits to below the borrowers' outstanding balances -- sending those cardholders over their credit limits without any charges being made. How's that for customer unfriendly?
Thankfully, the CARD Act does have something to say about charging fees to cardholders who exceed their credit limits. "The first thing to note is that issuers can no longer charge over-limit fees unless a consumer opts into the service. So even if the bank lowers the limit below the person's balance, they can't charge a fee unless the consumer has opted-in," Bowne says. For borrowers who have opted in, "the issuer can reduce the credit limit immediately but must wait 45 days to impose a penalty fee or rate," Wu says.
While the bank still has the right to lower your credit limit, here are three steps you can take to protect yourself:
Don't opt in. As discussed above, you can only get hit with an over-the-limit fee if you give your bank permission to do so. "So if the consumer does NOT opt in, they cannot be charged an over-the-limit fee. It's very important for consumers to avoid opting in," Wu says in an e-mail.
Transfer your balance. If you have paid your bills on time for a long time, there is a good chance you can transfer your balance to another card. Analyze the balance transfer fees to make sure this is a good deal.
Request a higher limit. Since FICO considers the total of all a borrower's account balances compared to the total of all their credit limits when determining the utilization ratio, getting higher limits on any of your cards could help your credit score. However, since some experts warn against requesting a higher credit limit -- since an account review by your lender could result in worse terms -- it may be best to first make that request of any banks whose cards you don't carry a balance on.
Along with a higher credit score, that's another good reason to pay off your balances. "Once you are free of credit card debt, you will be less dependent on credit issuer practices," Bowne says.
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