Reducing available HELOC and credit card limits will ding good credit

I have never checked my credit score. I have always used credit sparingly, and I’ve never been denied a loan. So, I’ve never really worried about my score until now.

No, I’m not overextended, but I utilize a home equity line on occasion to float larger purchases like a car. In the wake of massive foreclosure rates, banks are pulling back from their best customers as part of an overall credit squeeze. In the case of home equity lines, the pullback is even more pronounced because of dropping home values. The unintended result is that, if my bank decides to reduce the available balance on my HELOC, my credit score will drop. 

One major factor in determining a FICO score is the “credit utilization rate.” This is calculated by dividing outstanding balance by available credit limit. The higher the CUR the lower the FICO score.

For example, if a borrower owes $40,000 on a HELOC with a $100,000 limit, the CUR is 40%. However, if her bank decides to reduce the available credit limit to $80,000, despite never being late on a single payment, the borrower’s CUR rises to 50%. The result is a lower FICO score, and the borrower may not even realize the damage until she applies for a loan.

Bankrate.com recently reported a case of a borrower’s $100k HELOC being reduced to just $12k, the outstanding balance. The CUR on the loan exploded from 12% to 100%, thereby crushing the borrower’s credit!

Of even greater impact than lowering HELOC credit limit is the recent widespread move by banks to lower credit card limits. Large credit card issuers, such as HSBC, Wells Fargo and Washington Mutual have just begun systematically lowering credit limits.

Even though banks must notify borrowers of a drop in available credit, they have no obligation to disclose the negative impact the move has on credit scores.

While the tightening of credit is probably not a bad thing, the short term ramifications to consumers could mean not qualifying for the lowest possible rates.