The Ticking Credit Score Time Bomb—Are You At Risk?

By Eva Norlyk Herriott

You play by all the rules to keep your credit score high: Pay your bills on time; pay more than the minimum on credit cards each month; even keep the balances on credit cards at around 30-40%.

Yet, while you think that all is well, your credit score could be at risk.

Why? Credit card companies are looking to cut their risk. In the days of easy credit, they handed out credit cards with high credit lines left and right. Now, feeling the pressures of the credit crunch, card issuers are cutting back credit limits as fast as they can.

Tens of thousands of credit lines have already been slashed. However, we’re only in the early stages of a growing trend, and much more is yet to come. According to the Wall Street Journal online, financial institutions are projected to shave as $2.7 trillion off credit card lines by the end of 2010. According to analysts, to total available credit card lines available to consumers may shrink by as much as 57%. Interestingly, people with a good credit score are being targeted for credit line cuts even more frequently than people with poor credit, according to a study by Fair Isaac, the creator of the FICO credit score.

What does that have to do with the credit score? Unfortunately, if the credit limit is reduced, it could affect a key aspect of the credit score: the credit utilization ratio.

Let’s say that a person owes $4,000 on a credit card, but the limit is $12,000, so she is using only one third of the credit limit. This means that the credit utilization score, or debt to credit ratio, is at 33%; within a range that should guarantee the highest scores on this part of a credit rating. However, let’s say that the card issuer slashes the credit limit to, say $6,000. Now all of a sudden the credit utilization ratio is at $4000/6000, or two thirds (66%). Ouch! This is what makes a credit score take a hit.

This is exactly what has already happened to tens of thousands of cardholders over the past many months. In an effort to shore up their risk, almost half of U.S. card issuers, including American Express, Citigroup and JPMorgan Chase, reduced credit limits for their cardholders in the fourth quarter of 2008, according to a Federal Reserve survey.

The credit utilization rate accounts for almost a full third of a person’s credit score. If you don’t have much other credit available to you, a credit line cut could decrease your credit score by 50 points or more, according to FICO.

Unfortunately, a lower credit score can turn into a vicious cycle that affects your other credit card accounts. When the credit utilization goes up, other card issuers may raise your interest rates or cut your limit, because it looks like you’ve maxed out your credit card.

How can you protect yourself?

1. Keep credit card balances low, preferably at around 30% of available credit.
2. Have more than one credit cards, preferably 3-4 cards, so that if the credit line of one card gets cut, it will have less of an effect on your overall credit available.
3. Use all your cards regularly. Inactivity can be another ground for slashed credit limits.
4. Always pay your credit card on time and pay more than the minimum due. Preferably pay 7-10 days before the bill is due.

What to do if your credit limit is lowered:

1. If your credit limit is lowered on a card, explore ways to pay down the balance on your credit card as quickly as you can.
2. Apply for a new credit card and transfer some of your balance to a low interest credit card. It takes some time for credit scores to adjust, so while your score is high, you should be able to get another credit card deal with an additional credit limit to help offset the loss of the other credit limit. (Note: this strategy will only work if your credit score is good. If not, applying for a credit card won’t get you anywhere and it could hurt your credit score further).
3. Pay your card online before the monthly statement arrives to reduce the debt reported to the credit scoring agencies.

Published: May 22, 2009