“My bank recently reduce the limit on my credit card, and I have no idea why. Why would they do this if I’ve never missed any payments before, and how does it affect my credit score?”

This is one of the most common questions we’ve been getting from readers lately, and there are two reasons for it. Recent statistics have shown that roughly 1/4 of all credit card holders have had their credit limits reduced within the last six months. The recession has a lot to do with this. In particular, the mortgage and housing crisis that fueled our recession has caused a lot of lenders to minimize their risks.

Credit cards are a classic form of risk for banks, because they are not secured by any form of collateral (with the obvious exception of a secured credit card). So many banks have reduced credit limits for thousands of the customers, as a way of minimizing this risk.

That’s one reason they are reducing limits on cards. But there’s another reason as well. Starting in July of 2010, some new laws will go into effect to regulate what credit card companies can and cannot do. A lot of the things they have done to make money in the past will no longer be permitted. Some of their favorite tricks and tools for making money will be outlawed. Because of this, many banks are less willing to take risks. The money they have made in the past over penalty fees and other charges has offset their financial risks. But if they can no longer use these tools to make so much money, then they must scale back on the amount of risk they’re willing to accept.

In most cases, the people who are finding their credit limits reduced fall into a certain “profile.” The banks use various formulas and criteria to determine which customers are most likely to miss payments on their cards, and then they reduce the credit limits for these people.

This is usually why it happens, but not always. I have received quite a few emails from people who had their credit card limits reduced recently, even though they never missed a single payment in the past. Sometimes the banks apply these rules across the board, and other times they use certain formulas to identify high-risk customers. It just depends on the company.

Does a Reduced Credit Limit Hurt Your Score?

The usual follow-up question we receive on this subject has to do with credit scores. What happens to your score when the bank reduces your limit on a card? The answer is that it depends. Your score may go up, it may go down, or it may remain unchanged. It depends on what else happens in conjunction with the limit reduction that has been imposed.

Generally speaking, a reduced credit limit would lower your score, because it makes it seem like you are using a higher percentage of your available limit. For example, if you are using 15% of your available credit card limit, and then the bank lowers the limit by a significant amount, your utilization ratio will increase. In other words, the percentage of your available credit that you are using will go up. This happens even if your balance stays the same, because it’s not a measure of how much you owe — it’s a measure of what you owe compared to what’s available. In other words, it’s a comparison between your current credit card balance and the limit you have available on your credit line. So a reduced limit will actually increase your utilization ratio, and that can affect your credit score in the long run.

The best thing you can do if your bank reduces your limit is to pay down your balance. By doing this, you will minimize the changes to your utilization ratio, and therefore minimize the impact on your score.

Keep in mind also that there are several factors that influence your credit score. See the scoring chart below for an illustrated example of this.

The amount you owe on your cards compared to your credit limit (i.e., utilization ratio) is only one of five key factors. Your payment history is another major factor, and it influences your score more than a credit limit reduction. So if you continue to make all of your payments on time, and if you can pay down your credit card balance to compensate for the reduced limit, you could prevent any damage to your score.

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