Reduced Credit Card Limits Hurt Consumer Credit Scores

We spend a great deal of time in the credit industry educating consumers about credit utilization and explaining why it's important to understand the term. As banks and other card lenders are currently reducing credit limits for tens of thousands of consumers across the country, we are once again reminded of the important role credit utilization plays in determining FICO scores. What's worrisome is that those who have been negatively affected by the current situation might not even realize it until they apply for a new credit card or loan, and then get denied because their credit score has significantly dropped. So, for those of you hearing the term for the first time, credit utilization measures how much you are spending of your available credit limit from all cards combined. For example, if your combined monthly credit limit is $10,000 and you spend $3,000 per month on your credit cards, your credit utilization is 30%. Here's how a reduced credit limit can unknowingly hurt your credit score: Let's imagine an individual has one credit card with a $10,000 limit. As business conditions continue to weaken in the US marketplace, credit card issuers are looking for ways to reduce the risk of default, and a large balance on a credit card is clearly a higher risk than a low balance. In response, the credit card issuer chooses to lower the $10,000 limit to $6,000, which increases the consumer's credit utilization from 30% to 50%. Since credit utilization is a key factor in determining one's FICO score, this individual's score will most likely decrease as soon as the 30% threshold is crossed. In addition, even though the government requires credit card companies to notify consumers at least 15 days prior to making any changes to an account, they are not required to explain how the reduced credit limit could affect credit scores. Therefore, the responsibility lies on consumers' shoulders to understand the potential effects, pay close attention to any notices from credit card issuers, and respond appropriately. In recent years it was common for consumers to receive notices from credit card issuers announcing automatic increases in card limits, which were generally hard to decline even if they weren't desired. As home prices soared, banks were also substantially raising limits on home equity lines of credit, or HELOCs, based on inflated valuation models and their underlying hope that consumers would continue gobbling up the newly available credit for the next family vacation or home renovation. Not surprisingly, many consumers did, and now they are finding themselves in difficult positions as home prices plummet and cash is getting hard to come by around the average American home. According to recent data released by the investment bank, Merrill Lynch, net home equity draws decreased nearly 60 percent over the last year while revolving credit usage sharply increased at a year-over-year growth rate of 8 percent- nearly triple the annual average. In the absence of alternative options, consumers have clearly been forced to turn to credit cards as a source of liquidity, which will now be limited even further. And in the face of increasing energy prices, falling home prices, and a weak job outlook, the last thing you need to worry about is a lower credit score that might cost you thousands when applying for a loan. The key is to remember that credit card issuers are looking to reduce their risk of default, so you need to make sure your account is not targeted as one that might be risky due to credit availability. Pay your bills on time, never exceed your credit limit, be certain you have sufficient funds in your bank account before processing a payment, and strive to keep your credit utilization between 10-30%. Slip up once in this unforgiving marketplace, and credit card companies will likely respond by limiting your access to the credit you may desperately need.