Do lower credit limits mean lower credit scores?
By Erica Sandberg
September 20, 2013
I lowered my two credit card limits several years ago as protection against fraud. Now they say lower limits mean a hit on credit scores. Should I get another card or two with higher limits? — Dennis
The misinformation this “they” character disseminates is outrageous!
Of course there is no single person who is passing off rumors and half-truths about credit. Myths abound, and have for ages. This is one that's based on correct information, but it careens off in an odd direction.
The fact is, lowering credit limits results in credit rating problems only when the cardholder is already carrying debt. Not just a few bucks, either, but enough to throw the credit utilization ratio out of whack.
What's this ratio thing, you ask? Only the second-most important factor in a FICO score. The first is the way you make your payments, which accounts for 35 percent of the score. Pay on time, every time, and you have that covered. But the amount of money you owe in relation to the amount you can borrow is 30 percent of your score. In other words, it's the borrowing ability you utilize.
Because FICO scores are checked most often by lenders, they're geared to their needs. So imagine that you are considering someone for a loan or credit card. You'd want to see that the applicant manages credit well — that they can borrow money, pay it back and keep their debt in check. If the person owes too much, it would appear that they can't really afford their lifestyle and so have to borrow for it. That's probably not your ideal customer. If you grant the loan, he or she might fall behind on payments. Worse, there's a risk such a customer will go too far and default.
A good rule to follow is to keep your credit card balances below 30 percent of what you can take out. That means that if you have a couple of cards with a total charging limit of $10,000, you'll want your revolving debt to be no more than $3,000. If you reduced your limits so you were able to charge just $5,000, but kept your balance at $3,000, you would owe more than half of what you can borrow — which busts your utilization ratio. Your score takes a hit, and lenders back away.
You can do a couple of things to rectify the problem:
- Request higher limits on existing cards. If you have other accounts with low limits, consider asking for a credit limit raise. If you have a long history of using the cards well, issuers may be happy to boost your spending limits.
- Pay your debt down. When you delete balances, you reduce your utilization ratio. Less is best, for reasons besides your score, though. Hanging on to credit card balances is expensive because of the added interest, and you still have to make monthly payments, which eats into what you have left for expenses that month.
You ask if getting a new card will help, but your FICO scores have to be good (at least in the mid-600s) to qualify for one with positive terms. If your scores are low because your utilization ratio is poor, don't bother until you've fixed it.
Regarding fraud, I understand that you want to protect yourself from this crime. And you should. So check your credit reports. You can get one for free every year from each of the three credit bureaus at AnnualCreditReport.com. Read your reports carefully, looking for accounts that aren't yours or anything else that seems suspicious. Always examine your credit and banking statements, too, looking for balances that appear too high or purchases you did not make.
Take solace in another important fact: You are not responsible for fraudulently opened accounts or debts that you did not incur or authorize — no matter what “they” say.
If one pops up, you'll just need to dispute it with the bureaus to have it scrubbed from your record. You'll need to contact only one of the bureaus (TransUnion, Equifax or Experian), as it will be legally obligated to contact the other two. Once that's done, you can ask the bureaus to place a fraud alert on your credit profile so that you'll be contacted if anyone else tries to open accounts in your name.
So, as you can see, Dennis, there are ways to deal with fraud besides fencing yourself into a smaller credit limit.
Got a question for Erica? Send her an email.