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.

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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."

How much could that credit score drop?
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.)

Why?
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. http://vrtmg.com/framirez