Lenders are cutting credit limits and cancelling cards, even when credit behavior is innocent.
Some 33 million people, roughly one in five borrowers, had their credit limits slashed over the past six months–mostly without provocation, according to new research by Fair Isaac Co., the company that created FICO credit scores.
The average consumer lost 14% of their borrowing power in this latest wave of cuts, as lenders took away an average of $5,100 in borrowing power by either cutting consumer credit limits or closing accounts. A similar study conducted six months earlier showed a much more modest cut in credit limits, as the average person lost 5%, or $2,200, in borrowing power.
The vast majority of consumers who lost borrowing power appear to have done nothing to provoke the cut, such as make late payments or start borrowing more heavily, said Craig Watts, spokesman for Fair Isaac in San Francisco. Watts qualified that Fair Isaac is not privy to every factor that would affect credit decisions, but there was no sign of trouble on 25 million credit reports out of the 33 million that saw their credit lines cut, he said.
Unprovoked cuts to credit limits, a common complaint during the current credit crisis, have sparked worries that innocent consumers could find their credit scores savaged, making it harder to borrow at decent rates in the future. That’s because credit “utilization” is a significant factor in determining your FICO score, which is a number between 300 and 850 that aims to handicap the likelihood that you’ll repay your debts.
Credit utilization rates are determined by comparing the amount of debt you have outstanding to the amount you have available. If you have $100,000 in available credit, but are only using $50,000, you’re utilization is 50%, for example. When credit limits are cut, utilization figures are arbitrarily raised. If lenders took away $20,000 in borrowing power from this hypothetical consumer, for instance, he’d suddenly see his utilization rate soar to 62.5%, without adding a penny to his debt.
Fair Isaac says heavy debt utilization is a significant determinant of credit risk. Those who utilize 70% of their available credit are up to 50 times more likely to default on their debts than those who utilize 10% or less.
However, the study found that the impact to FICO scores has been mostly modest, perhaps because consumers have been paying off their debts as fast as their banks could slash their limits. The bulk of the 25 million people who had unprovoked credit limit cuts had a relatively minor 20 point swing in their before-and-after credit scores, according to the study. And, ironically, more scores rose than fell. The average FICO score for this group was 760, according to the study, which is good enough for the best credit offers.
Only a relative handful of consumers saw their scores drop by 40 points or more. Watts speculates that these were people with “thin files,” or those who had few loans outstanding and had relatively short borrowing histories.
Watts gives little advice to those who had their credit limits arbitrarily slashed, except to say that the best scores go to those who follow Grandma’s advice: Borrow sparingly and pay your bills on time. That advice stays true in both good times and today’s rotten credit environment.
