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Got Credit Limit Decrease?

By Richard D’Alessio

While virtually every aspect of our economy is melting down, so also is your access to capital.  Banks and credit card issuers, faced with uncertain futures with regard to defaults and government cash infusions, are shedding some of their risk by decreasing your unused lines of credit.

If it hasn’t already happened to you, pay attention to this article.  If it has happened to you, we’ll explain why and what you can do about it. 

Nick from New York has run a seasonal small business since the early 1990’s.  His business drops off around November and starts up again in the spring.  He’s grown his business every year, been profitable, and has established credit.  And he’s been good about paying his loans on time and living up to his term agreements.  He’s been so good, in fact, that he earned a $250,000 credit line in the last few years.  He uses that credit line to keep his business going during the winter and pays off his credit line during the summer.  Things changed drastically at the end of November 2008 and now he’s effectively out of business and his employees are out of work.

Nick received notice from his bank that they would be reducing his credit line by $150,000.  Nick already had a $100,000 balance on the line, which left him with no more room.  He’d been planning to use more credit through the winter and pay it back in the summer, as he had done for the past few years.  And because he was now “maxed” out on the majority of his credit, his credit score dropped which severely limited his ability to get new credit elsewhere.  So now Nick’s out of business, done in by a bank that his tax dollars are bailing out.

But is the bank to blame?  It’s hard to say.  The banks are being told by the government to figure out their default liability before they can receive another bail out.  And the banks also know that with the economy heading where it’s heading, people are more apt to utilize their credit and load up on debt.  And today, more than any time in recent history, chances are stronger that a large portion of credit users will default on their debt.

So banks are going through their customer lists looking for clients who are adding more debt than they are paying off.  It just turns out that timing of the meltdown hit Nick on the wrong cycle of his business.  If the down turn hit in the spring, when Nick was paying off debt as opposed to incurring more debt, his credit line may have been left in tact.

American Express Manager of Public Affairs, Lisa Gonzalez, stated that in a typical year, fewer than 20% of cardholders experience a credit limit adjustment, and most often, it is a credit increase.  After mid-2007, the ratio became 50/50, meaning there as been over a 100% increase in cardholders who have had their credit decreased since mid 2007. 

The same story has been echoed among most credit issuers, especially with regard to credit lines.  Credit lines are usually tied to property values.  When property values decrease, the risk exposure to the bank loaning money based on the value of that property increases.  In many cases, there is more owed on a given property than the property is worth.  And now two things are happening in large number, people are defaulting on their debts and banks are closing or decreasing credit lines that haven’t yet defaulted. 

As the vicious cycle continues, less credit will be available to the increasing number of people seeking credit.  Statistics show that borrowers with less than perfect credit, or credit lines attached to sub prime mortgages face a 60% chance that their credit line will be decreased if it hasn’t already.

The banks are basing their decisions primarily on property values and debt to equity ratios.  This means that a borrower’s payment history will have very little to do with the bank’s decision.  The financial blogs are littered with stories about how people who hadn’t missed or been late on a payment had their credit limits lowered to equal to their debt—meaning no more credit.  It’s not personal.  The same thing is happening to the banking industry.  Their access to capital, i.e., government bailout, is dependant on their debt to equity ratios.  If they have lots of loans on their books, where customer debts are higher than property values, these banks will look insolvent and will most likely not get bailed out. 

So what can you do?  First, figure out your likelihood of getting your limits decreased.  If your debt to equity ratio is more than 40% (you owe $4 for every $10 you have in real equity like property) expect a reduction.  And when one reduction takes place, expect your credit score to drop, which will trigger further reductions. 

If you don’t feel you need access to more money, start paying off your debt and reduce spending so that you can live on a cash basis—both personally and with your business.  If you think you might need more money, max yourself out.  You’ll pay more in interest rates over time, but you’ll have a financial buffer to weather this 100-year financial storm.  Especially max out your credit line.  Rates are historically low, under 5% on most credit lines.  Max these out and consider paying off higher interest credit card debt. 

If Nick from New York had an opportunity to max out his credit line before it was taken away, he’d still be in business.  He would have also had more time to analyze the news, financial reports, and his own business trends to figure out how to prepare his business for an uncomfortable economy.

It boils down to simple logic, tough decisions, and a lesser of evils approach.  If you think you can’t live, especially in this economy, without the full access to your credit line’s limit, do whatever you can to get it—all of it.  Then, expect that you will pay interest on the money, even if you don’t spend it.  Expect that even at a low interest rate, it will cost you money to tap your credit line because you will not likely be able to earn interest anywhere on this money to offset the finance charge.  Only make the minimum payment because the bank will lower your limit anytime you give it the opportunity.  And finally, expect that you will not be offered more credit until such time that your total debt is at least less than 40% of your equity or a booming economy resumes with easier credit opportunities.  Bet on the former of these two scenarios. 
This strategy runs contrary to everything you’ve every heard about credit but it may keep you in business until the economy improves, property values begin to increase, and you can safely start paying down debt without risking further credit decreases.  And this may take a while so learn how to live without credit in the meantime.

 

 

 

 

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