How that huge credit limit can hurt you

A raised limit isn't a lender's challenge to your spending abilities, merely an indication it likes the way you do business. But big limits can crimp the rest of your financial life.

By Bankrate.com

Every credit card has its limits. Everybody knows that.

But do you know what your credit line says about you? Or the limits that hefty credit card lines can place on the rest of your financial life? Let's take a look.

First, a credit limit is much more than a cutoff point for spending. It's a reflection of how a particular credit card company gauges your credit worthiness and your likeliness to charge away on their card.

"Two banks can look at the same individual and have a different view of their creditworthiness," says John Grund, a partner with First Annapolis Consulting Inc.

And that's why one issuer might look at your credit record and offer you a card with a $5,000 credit line and another issuer might offer you a card with a $10,000 credit line.

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In general, the better your credit, the thicker your credit lines tend to be. Some issuers woo credit card customers with huge credit lines straightaway. Other issuers will wait until you've made a few months of on-time payments before boosting your credit line.

For example, after six months of on-time payments, an issuer might boost a $5,000 credit line to $7,500 or higher. And while issuers tend to limit credit line increases to once or twice a year, they're constantly monitoring each customer's credit status.

"What they want to see is demonstrated patterns of timely payments and no delinquencies," Grund says.

A larger line doesn't mean freedom
If a credit card issuer likes what it sees in your credit and payment records, those credit line increases will keep right on coming, whether you can actually afford them or not.

"A lot of larger issuers run automatic line increase programs," says Ali Raza, a vice president at Speer and Associates Inc. "They use that opportunity as a loyalty-building tool and to increase balances."

And it's working. Credit lines and debt levels are swelling. It's been happening for years.

In the go-go 1990s, competition in the credit card industry was so fierce that issuers offered cards to more consumers without established credit histories, including college students, and to more folks with less-than-perfect credit.

Issuers also courted good credit customers with thicker and thicker credit lines.

The result? A massive increase in the number and size of consumer card lines.

Today, many credit card customers have more available credit than they could ever need or handle.

The numbers reveal the plight
Consider these statistics from Demos, a nonpartisan and nonprofit public policy research and advocacy group in New York.

At the end of 2002 (the most recent statistics available), families owed more than $750 billion in credit card debt--an average of $12,000 per indebted household.
Between 1989 and 2001, middle-class families saw their credit card debt increase by 75 percent.
The lowest-income families' card debts grew by a whopping 149 percent.

"These balances are unmanageable for families struggling to make ends meet," says Heather McGhee, a program associate at Demos. "We talk to families all the time with $40,000 to $50,000 of credit card debt, and they'll be paying off credit cards through retirement."

Think twice before taking offers
Anyone carrying a lot of credit card debt should probably rebuff offers for credit line increases.

Why agree to a bigger credit line when your current card debt is already draining your bank account? Your top priority should be paying down your current debt.

And it's not a good idea for any card customer to view a credit line increase as a signal to spend. "They don't know your financial situation. They're looking at whether you've paid as agreed," says Bonnie Spain, chief executive officer of the American Center for Credit Education.

"They don't know if you can afford the increase. Only you can determine if you can afford the additional payment and the additional debt."

Turning down a credit line increase is easy. All you have to do is call an issuer and ask.

Remember, when determining credit lines, card issuers have their bottom lines, not your best interests, at heart. And issuers aren't shy about protecting their bottom lines.

Credit lines can tighten, too
More and more lenders will reel in your credit line if they see something on your credit record that makes them nervous. Pay late on your card bill or with another creditor, bounce a check or take on a big loan and don't be surprised if your credit card's roomy credit line gets a lot less roomy in a hurry.

"Larger, more sophisticated issuers are very, very aggressively marketing credit lines both upwards and downwards," Raza says.

Even card customers that pay off their card balances each month may want to think twice about accepting every credit line increase that comes their way. The reason?

Lenders view all open credit lines as potential debt. Too much unused credit may affect your ability to qualify for a home or a car loan.

"Lenders are cash-flow bankers," says Paul Richard, executive director of the Institute of Consumer Financial Education in San Diego. "And no lender is going to make you a deal when you have all that credit available and not consider what you might do with it."

So folks with six or more credit cards and no debt may want to trim back their credit lines before applying for a home or car loan. Cutting back your credit lines won't boost your credit score, but it may make a lender feel more comfortable about approving you for the big secured loan that you really want.

Don't cancel cards before a major purchase
Consumers with credit card debt who plan to buy a car or home soon will want to keep their credit lines right where they are. Canceling a large amount of unused credit lines when you have credit card debt could actually hurt your credit score.

Here's why.

Credit-scoring models look at a number of factors when calculating your score, including the result of the following formula: the total amount of debt on credit cards and revolving accounts divided by the total amount of debt available on those accounts.

This formula results in a fraction less than one. The lower the fraction, the better. A score of one would mean your outstanding debt equals your available credit and you've maxed out your credit cards. Let's look at an example. Let's say you've got $5,000 of debt and $15,000 in credit lines. By dividing 5,000 by 15,000 you get one-third. You're using one-third of the credit available to you.

Now let's say you cancel an unused credit card with a $5,000 limit. You've still got $5,000 of debt but only $10,000 in credit lines. By dividing 5,000 by 10,000 you get one-half. You're now using one-half of the credit available to you.

The closer to one this fraction gets, the more it hurts your credit score. The best advice for a home or auto shopper with credit card debt is to pay off as much debt as you can and hang on to all your credit lines until after you've landed your loan.

Can't control spending? Get help
If you're in credit trouble or if you had credit problems in the past and a hefty, unused credit line is only going to tempt you to spend, call the issuer and ask them to reduce your credit line or cancel the card altogether.

Yes, it may ding your credit score a bit. But if it will keep you from acquiring more debt, it's best to do it. You can worry about building up your credit score after you're back on your feet financially.

Read "How to cancel a credit card" to learn how to do it right.

A good strategy for keeping your credit card spending in check is to limit yourself to just one or two credit cards. This will make it easier to monitor your debt and your spending.

"If you have too many credit cards, you can spread the debt out and fool yourself," Spain says.

Create a cash cushion
A great way to break free of the dreaded credit card debt cycle is to establish an emergency fund. That way you'll have the cash to pay for a big expense that pops up out of nowhere.

"There isn't a person who hasn't gone through a year without an unexpected expense," Spain says. "It could be a medical expense. It could be a car repair. It could be something in your home broke down."

Without an emergency fund, those expenses get piled on credit cards and can linger for months or even years. Having some cash in reserve for unanticipated expenses can make a big difference to your family's financial health.

Socking away three to six months of living expenses is ideal. But any amount of cash you can tuck away is a good start.

"Having the cushion, having the savings is an extremely important part of managing your money," Spain says. "Any amount makes a difference. Don't get discouraged. Start. Take it in steps."