Vision Credit Education, Inc.

FICO scores have faced a lot of criticism from consumers that have had their credit limits slashed recently. Most argue that it is unfair that their credit scores drop due to arbitrary credit limit reductions by creditors. However, the higher risk caused by market conditions does justifiably affect your scores, even if the lower score is caused by your creditors dropping your credit limits. While the cause is not necessarily fair to you, here is how it is justified.

Credit Limit Utilization

First of all, you should understand the root cause of the problem. A full 30% of your credit scores depend on factors that directly depend on your credit balances. The more debt you have, the more your scores may drop. Of course, it does get more complicated than that.

A higher balance on an installment loan will not affect you to the same detriment as a high balance on a credit card. In addition to the sheer amount of debt that you have on credit cards and other lines of credit, the formula also takes into account how much of your total credit are you actually using.

Your credit utilization rate is a calculation that shows the percentage of your revolving credit that you have used. A card with a $10,000 credit limit and a $5,000 balance has a 50% utilization rate. If that lender drops your credit limit to $7,000, then your utilization rate just jumped to over 70%.

This can be very difficult for debtors, since it can cause their scores to drop when a lender cuts their credit limits. While many affected cardholders are calling foul on the policy, it is actually justified.

It is true that market conditions have caused the change rather than the consumer initiating the change. However, a debtor should realize that by carrying a debt in the first place, they are vulnerable to market fluctuations.

A drop in the credit score does accurately portray a higher level of risk because that cardholder will face the following additional difficulties:

• First, their other creditors may see the adverse action on that account and follow suit with credit limit reductions of their own, which can further erode the debtor’s financial situation.
• Second, the debtor may find it more difficult to pay off debt through home refinance or equity lines. They may have a harder time transfering balances to other credit cards also. Even if they do, the rates and term of promotional rates will not be as attractive as before.
• Third, the debtor is now much closer to maxing the card out. If they incur an unexpected expense such as a vehicle repair bill, then they could have difficulty paying that bill without going over the limit on their account.

While FICO CEO Mark Greene certainly may have a biased opinion, he did accurate sum up the reasoning behind the FICO model as it relates to credit limit reductions and the credit utilization rate in a recent Bloomberg article:

It’s not obvious to me that having the score change because of limit cuts is the wrong thing. The bank’s action may signal a riskier environment and the view that you are a riskier consumer.

It is indeed true that the changes made by creditors do adversely affect the credit scores of debtors. FICO is still a reasonably accurate measure of this risk. As long as a household carries unsecured debt balances, they are vulnerable to whims and business decisions of their lenders. The only true way to protect yourself is to pay off the balances completely.