Banks have found themselves in a world of hurt through this economic downturn. The government requires them to hold some money in reserve to cover a predetermined percentage of potential losses. Since the value of their assets have fallen and since banks have been facing growing delinquencies many have struggled to maintain an adequate amount of reserves.
There is a saying, “If you can’t raise the bridge, then lower the river.” For some banks, if they can’t raise enough capital for ample reserves they in turn are reducing their amount of liabilities. One way they have accomplished this is by dropping the credit limits on credit card holders.
The big concern for us is how this reduction of credit will affect our FICO score. According to this 13 page document titled How Are Credit Line Decreases Impacting Consumer Credit by the Fair Isaac Corporation, 20% of consumers have had their credit limit reduced. On average each person had $5,100 of their credit limit taken away.
As you may surmise, this can affect your credit score negatively. As an example, if you have a $10,000 limit on your credit card with a $1,000 balance your “utilization rate” or the percentage of available credit used is only 10%. If your limit was reduced $5000, your new utilization rate would double to 20%. With just one more car repair you could end up with a 30% or higher utilization rate.
As we learned in an earlier post called Your Credit Score the “utilization rate” or debt/credit ratios make up 30% of your overall FICO score. This is the second largest component of your score behind the history of payments.
It seems logical that a reduction of credit of over $5000 would certainly have an impact on your score. But according to the document by Fair Isaac Corporation noted above, in most cases the impact will be negligible.
They ran two analyses, one was a simulation against a “representative” sample of the population. Using three different scenarios FICO determined that on average a reduction in credit limits did not have a substantial impact. They ran the simulation using 10%, 25%, and 50% reduction in credit. Take a look at the chart on the right copied from Fair Isaac’s report. This reflects their findings, on average even with a 50% reduction in credit there was only a 9 point drop in FICO scores. Do you think the banks are reducing the credit limits of a “representative” sample of the population?
The other study reflected observed changes for consumers that had “no risk triggers” but did have an actual reduction in their credit. Most of their data focused on the 14.5% of the population that had “no risk triggers”, meaning no late payments or other known factors that would have caused the lenders action. For these customer’s it may have been simply an inactive account that was closed or reduced. If you have “no risk triggers” it would make sense that in most other areas you already have positive factors for your FICO score. Therefore the impact of a reduction in credit limits should not be significant. What is not really clear in their data is the 14.5%, is this of the entire population or only of the 50+ million people that had their credit reduced in the last year?
However, as usual, when you dig a little deeper into the data there are few questions raised. For example, the 20% of the population that experienced a reduction in credit limit “in the most recent time period” had their credit limit dropped between October 2008 and April 2009. This was an increase from 15% in the earlier April 2008 to October 2008 time period. To me, this means a total of 35% of the population experienced a reduction and more are still occurring. Heck another whole six months has passed since this data was used, we could now be well over 50% of the population.
What will the impact be to you? In the extreme case, the impact may be large. Depending on the other factors used in your credit score you may be negatively impacted enough to be forced into higher brackets on interest rates for mortgages or car loans.
If your bank tries to reduce your credit limit, what can you do?
Your best approach might be a direct one. Call your bank to inquire, politely, why the decision to drop your credit has been made. Explain that you have been a loyal customer and would like to continue the relationship (assuming you have been a loyal and good customer, of course). Another tactic might be to explain that this change would tarnish your good credit rating. Be willing to negotiate, get the limit high enough over your balance to be favorable. Let’s face it, you won’t get anything unless you ask.
If all else fails, your focus is really the ratio between your debt and credit limits. Reduce your debt load by an amount similar to your credit limit reduction. While most news report suggest a debt/credit ratio of 30% the data I shared yesterday clearly showed that my best score could only be achieved with a 1%-10% debt/credit ratio.
One other option is to go out and get another or additional credit cards to increase your overall credit line. This doesn’t mean that you run up your debt however! Charge a few items and pay them off immediately. Understand however this will reduce your average age of credit and have some negative impact as well. But the age of your credit only has a 15% weighting factor vs. a 30% factor for debt to credit ratio.
One thing not to do is close your account with a balance still pending. Getting angry at your credit card company and closing your account automatically eliminates your excess credit limit and makes it appear that you have maxed out the credit you do have. Always pay off a credit card in full before closing the account!
Have your credit card companies dropped your limit? How did you deal with it? Please share your real world experience and advice with other readers. True stories are always better than “data” from the papers.