Monday, July 14, 2008

Lowering Your Credit Limit is Stupid (plain and simple)

On Friday I heard some of the stupidest advice about credit card limits. On one of my favorite credit message boards, some guy (no doubt a troll) suggested lowering your credit limits so that you could avoid the "credit trap."

(Editor's Note: If your limit is being lowered by your credit card company -- to just above your current balance -- then you are interested in my "chasing the balance" story (link here).)

The guy didn't do a very good job of explaining what the so-called credit trap actually means, but I inferred that he meant many consumers have high limit cards that are maxed out. Those maxed-out cards, meanwhile, are accruing interest at a hefty rate. This guy's solution, then, was to reduce the limits to insignificant levels. He said that he originally had a $5,000 limit card but that it was now at $500. Another card was originally at $1,000 but was now only at $300. He says now that he rarely uses those two cards. Bully for him. Personally, I think his advice was absolutely lame and reckless. I also got the impression that he was utilizing cash a lot more.

(Without knowing much about this person, I suspect that the guy got into some serious problems with his cards in the past. He probably couldn't control himself or his spending. Now, after recovering from that situation, he's gone all the way to the other side. He's probably on an all-cash diet and uses the cards only when it is absolutely necessary.)

In a previous post, I talked about the perils of using cash only. It seems to be the blueprint of choice for those who don't understand credit or for those who can't control their spending. But that's the topic of my other blog entry. Read it here.

As for lowering your credit limits, here's why it doesn't make a lot of sense. Assume that a person has $20,000 in available credit limits spread over four credit cards. Imagine further that this same person makes about $2,000 a month in charges on those four cards. The amount of usage equals 10% of the person's available credit. The good news is that the utilization (subject of a previous blog entry that can be found here) is low and it's something that FICO will appreciate.

Now let's see what happens if we do what our friend who worries about the so-called credit trap advocates. Instead of having that $20,000 in available credit, he'd advise you to take each of your four cards to limits that are just $500 apiece, which would give you available credit of $2,000. Here's where the situation gets dicey. Assuming our fictional person was still charging $2,000 a month, this person would be maxed out on the cards each and every month. This person's FICO score would be in the trash as well. That's because every card would be at 100% utilization.

Worse, imagine if our fictional character ran into an emergency during the month. Aunt Sally died and we need to get to her funeral in five days. We'll need an airline ticket on short notice and we'll need a rental car as well. Also, because so many people are staying at Aunt Sally's house, we'll need to stay in a hotel as well. It doesn't take a genius to realize that our $2,000 in available credit is woefully low. We'll never be able to put all of these short-term expenses on our cards (after all, we're maxed out just from our regular expenses during the month).

No problem, you're thinking. We'll just use cash to fund these emergency costs. Let's take a look at that idea for a moment. First, your rental-car company could pull your credit report because you want to use your debit card. The car company may also put a hold on a portion of your bank account balance (maybe as much as $300). The hotel, meanwhile, doesn't like you using debit card, either. It decides that it will be putting a $100 hold on your bank account balance as well. I've never bought an airline ticket with a debit card, so I am not sure about hold policies there. But I do know this: Aunt Sally lived in New York City. You live in Los Angeles. That short-notice ticket is going to cost you about $1500. You could have used miles that you earned from your credit card purchases over the years, but you've sworn off credit cards, which means that you probably don't have that option.

As you can see, our poor slob who has decided to slash limits to the bone is now unprepared for an emergency. Worse, all of this pain was self inflicted. That's lame. And it was so unnecessary.

The smarter person -- that's you -- won't be running into any such trouble. Indeed, you'll be prepared for a rainy day because you'll have credit limits that will serve you well. Your limits will be high enough so that emergencies don't max your cards out. What's more, you won't have to turn to your cash reserves prematurely. Your cash will be sitting in your interest-bearing account for as long as possible. Importantly, your FICO score won't be taking a hit on a regular basis. You'll be using your credit on a regular basis, showing that you can handle it responsibly, and you'll be keeping your scores high.

Sadly, I imagine that there are a lot of people out there who think just like the guy who was talking about the credit trap on Friday. They're woefully underexposed to credit and they're one emergency away from having to scramble to make things work. What's more, they're moving from one perceived credit trap and jumping into a new credit trap (where they have no available credit).

Fortunately for you, you're not going to be one of those guys. Keep your limits high and don't sweat the small stuff.

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GoldenDomer said...

When I pulled up my blog this morning , I saw your blog updated. I'm constantly amazed at the advice some offer - yours I can handle. I also like your statement about obtaining credit while you can, not when you need it the most. It is so true. Keep up the good work.


Anonymous said...

You made a good case for why it's important not to lower one's credit limit. Digg-worthy!

Credit Matters said...

Guys, thanks for the comments. I appreciate them.

And thanks for the digg, anon.

Carry on.

Anonymous said...

If i had 2 cards that the interest rate was being raised to 21% but i could not make a minimum payment on both cards the cards were only 3 years old and if i started having late fees and on the one card they lowered my credit limit i had no choice i was screwed both ways. said...

Anon, you would be screwed both ways. Higher rates and lower limits. Terrible double whammy.

Anonymous said...

I have only 1 credit card for personal use (I have another in my company's name that I use only for business). I pay the balance in full every month. The limit used to be $5000 but I rarely used more than $2000-3000 in any given month. Usual monthly usage is less than $1000. A couple of years ago the card was compromised and someone made a charge of $2700 on my card. Thankfully, the merchant recognized that the charge was fraudulent and reversed it but it was a headache. So I decided to lower my limit to $3000 to reduce my exposure to fraud risk. Maybe I hurt my credit score but frankly I don't care. I guess I'm a freak. said...

Anon, no worries. If you're happy, I am happy. I should change the headline. That "stupid" thing should be eliminated.

I wrote this story about eight months ago.

Anon, do what works for you!

Anonymous said...

double edged sword here really... either you constantly owe the cc with high interest rates, or if you lower your score (within reason, not down to $500, but more like $3000) you will have a higher interest rate on loans etc. I'd rather NOT pay the fu%^ing cc companies every month like i do now, keep it at a number I can handle, and owe more to whatever (car) loans etc.
If this economy has taught us anything, it's to take alittle more time, SAVE some cash, and put it down towards a(car loan) and pay the rest off. Id rather do it that way. bc right now, i want to buy a car but still am stuck paying off the cc. Im spinning my wheels this way, when i get it to around 2,500, im gonna ask that my limit be dropped to 3000, and then continue to pay it down from there. I consider myself a financially responsible person, but it's all too easy to get caught up in debts, its not always the "stupid" irrisponsible people.

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