As consumers become more and more reliant on credit to help pay bills and get by from paycheck to paycheck, they’re being hit with a double whammy! Credit card companies are starting to reduce borrowing limits for thousands of card holders nationwide – inadvertently leading to lower credit scores.
Consumers in this situation may not even be aware of it until they apply for a mortgage or another credit card, and then get denied because their previously good credit score has plunged.
This is an unintended consequence of the unraveling of the credit market in the United States as every financial company is now trying to reduce as much risk as possible. Banks and other card lenders are trying to better protect themselves from the massive losses like those from the recent subprime mortgage meltdown.
Card Companies Reducing Their Risk
As a result, they are looking for ways to reduce their exposure to cardholders more likely to default. That’s why they are lowering credit limits, which means they are reducing the maximum amount of credit extended to an individual, along with boosting card interest rates and allowing fewer balance transfers.
“This is what they have to do at this time,” said John Hall, a spokesman for the American Bankers Association, a Washington-based trade group.
At the same time, revolving credit usage — which includes credit cards — accelerated sharply to a year-over-year growth rate of about 8 percent in recent months. That’s the fastest rate in seven years and well ahead of the 2 to 3 percent rate of growth from 2004 through 2006 when home equity lines of credit were a bigger source of cash for consumers, according to Merrill.
But as credit cards are used more frequently, bigger balances outstanding on the cards. What’s troubling is that card holders, who are faced with a number of ugly economic scenarios hitting at once, like falling home prices, sky rocketing commodities costs and a bleak employment forecast, may not be able to pay their bills.
American Express has indicated that many of its customers are falling behind on monthly payments. Some Wall Street analysts have suggested that the stock forecast that the card company in 2008 will head lower on this information.
With the unstable US Economy, card companies like American Express, Capital One and Wells Fargo are reducing credit limits on their customer’s cards.
“In the purest sense, it is the better way to manage the risk of a cardholder,” said Linda Sherry, director of national priorities for Consumer Action, a national non-profit consumer rights and education group. “But a low credit limit can also unknowingly hurt a credit score.”
Here’s how that happens: Let’s say a cardholder has a credit limit of $10,000 and a balance on the card of $4,000. The card company worries that large balance may increase the prospects for default, so it lowers the credit line to $5,000.
But in doing that, it completely changes what is known as the credit utilization rate, raising it from 40 percent to 80 percent. Credit utilization is factored into the calculation of a person’s FICO credit score, which measures creditworthiness.
Consumers Left With Lower Credit Scores
A lower FICO score makes borrowing money much more expensive. For example, someone taking out a $25,000 36-month auto loan might receive an interest rate of about 6.4 percent, making the monthly payment $765 assuming they were in the highest range of FICO scores (720 to 850) according to myFICO.com.
For those with lower scored, we can see the drastic increase when the interest rate jumps to 7.3 percent and a monthly payment of $776 with a score of 690 to 719 and as much as 15 percent or $866 a month for those in the bottom FICO range of 500 to 589.
One of the government agencies that regulates U.S. banks mandates that companies must notify cardholders at least 15 days in advance before making changes in the terms of their account, such as lowering the credit limit. However, are not required to explain how those changes could affect a person’s credit score.
That puts the burden on consumers to watch their credit score for lower credit limits and increased credit utilization. Consumers are urged to get their free annual credit report so they don’t get blindsided with a lower credit score.
Where to Get Your Credit Report?
Experian – You can get a copy of your credit report for no fee.
Credit Score Review – Free Trial! – A free trial offer that provides all 3 nationally recognized credit scores.
AnnualCreditReport.com – A government sponsored agency that provides credit reports to consumers.
All Scores Instantly FREE – Includes Credit, Auto, Insurance,and Employment Scores.