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When Do Credit Limit Cuts Hurt Credit Scores?

 
By Eva Norlyk Smith, Ph.D.
October 31, 2009
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Personal finance experts generally advise against closing credit cards, because reducing the total line of credit available to you may hurt your credit score. However, according to a new study by FICO, having a lower total revolving credit line may not necessarily affect your credit score. Credit scores will only suffer under some circumstances, for some types of cardholders.

Before going into the results of the study and what they mean for cardholders, let’s take a quick look at why lower credit limits could lead to a lower credit score. The total credit limit affects a vital part of the credit score, known as the credit utilization ratio, that is, the percentage of the available credit used. Most experts recommend keeping the utilization ratio well below 30% to avoid your outstanding credit card debt from pulling down your credit score.

For example, if your total revolving credit on all credit cards is $10,000 and you carry a $3,000 balance on your cards, you credit utilization ratio is 30%. Now, if your card issuer cuts that $10,000 limit by, say $5,000, the credit utilization ratio instead will be $3,000 out of $5,000, or 60%, high enough to pull down your credit score.

Because credit card companies have slashed card limits for millions of consumers over the last year, a large question has been the degree to which this actually did affect the credit scores of those cardholders. According to the new FICO study, it does, but not as much as one would think, and not necessarily in the direction you would think either.

The study looked at the credit score of about 33 million cardholders, who had their credit limits reduced between October 2008 and 2009. FICO focused on an estimated 24 million consumers whose credit card limits were not reduced because of adverse risk triggers, such as late payments late or missing payments, high credit card balances, or a high credit utilization ratio. The credit limits of these cardholders were mainly cut because of inactivity as part of credit card companies’ efforts to cut back their revolving credit exposure.

The cardholders in the study group all had high credit scores, with most scoring around 760 on the 300-850 FICO score range. Most carried very low balances on their credit cards, and as a result, their credit utilization ratios were very low. The credit limit reduction averaged $5,100, which on average was 14 percent of this population’s total revolving credit. The highlights of the findings were:

  • About one third of the group, or 8.5. million cardholders, experienced a slight drop in credit score, typically around 20 points.
  • About 3.5 million saw no change in their FICO score
  • About 12 million cardholders actually increased their credit score after the credit limit cut.

Why the big variance? In its report, FICO points to several factors. First of all, other factors in the consumer’s credit history might impact the effects on the credit score. Secondly, the amount of credit limit cut could also affect the score. People who had less credit available, and thus would see a higher percentage of their total credit limit cut, would be more liable to see their credit score adversely affected.

FICO points out that how consumers reacted to the credit limit cut also had an impact. Some cardholders reacted by paying down other card balances or by applying for a new credit card to recuperate the lost credit line. Both actions would improve the credit utilization ratio, and thus could lead to increased credit score. On the other hand, cardholders who didn’t take any compensating actions might be more liable to see their score affected.

Lastly, consumers with high credit scores tend to have a low credit utilization ratio, and as a consequence, are much less vulnerable to a decrease in the available credit. On the other hand, consumers in the mid-range of the credit score spectrum are likely to have a higher credit utilization ratio, and therefore are more likely to see their credit score suffer because of credit line reductions.

The bottom line: You can’t do much to safeguard yourself against credit limit cuts, but you can prevent them from affecting your credit score. In addition to always paying your bills on time, keep your card balances low. Credit counselors recommend using less than 30 percent of your total available credit. However, in times of uncertainty like these, keeping card balances around 10% is preferable. That way, if your card limit is cut, your credit utilization ratio, comparatively speaking, will still stay within levels that won’t drag down your credit score.


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