Banks, fearing additional losses from consumers defaulting on their loans, have been reining in massive amounts of available credit. Even though these financial institutions are trying to protect themselves and their investors, in some ways, they’ve only made the credit crisis worse. Here’s how banks are damaging our credit scores, which in turn makes it harder for us to qualify for new loans and credit. It’s a vicious cycle that’s not easily broken.
How Banks Ruin Your Credit Score
Credit scores are the number that most banks use to determine whether to approve you for a loan. High credit scores indicate that you’re less likely to default on credit cards and loans. On the other hand, low credit scores mean you have a history of mismanaging credit, making you a riskier borrower. When banks responded to the credit crisis, some of their actions did a reverse-Cinderella treatment on borrowers, dropping their scores and making them less attractive borrowers.
Lower Credit Limits Lead to Lower Credit Scores
One of the ways banks responded to the credit crisis was to cut credit limits. Too much available credit, they said, presents a high risk of default. Unfortunately, credit cardholders suffer when a credit limit is reduced.
Part of your credit score – 30% do be exact – comes from your level of debt. That’s the amount of credit you have available. When your credit limits go down, so does your credit score. Your balances get closer to reaching your limits, not because you charged more, but because your limits were lowered. Your credit score drops not because of your actions, but because of the banks’.
Closed Credit Accounts Lead to Lower Credit Scores
Another way banks reduce their risk is by closing out credit cards that haven’t been used. After a few months of inactivity, your credit card issuer could close your credit card. At that point, your credit limit drops to $0. If you have a credit card balance, it looks like you’ve maxed out your credit card and again, you lose points in the level of debt area.
Closed credit cards also hurt other areas of your credit score calculation, like age of credit history (which is 15% of your credit score) and mix of credit (10% of your score). If your older credit cards get closed, your average credit age is shortened and you could lose some credit score points. In addition, if your only credit cards get closed, your mix of credit looks one-sided and you lose points again.
The Impact of Interest Rate Increases
Finally, banks can indirectly harm your credit score by hiking your interest rate. If you don’t want to be subject to a higher interest rate, you might opt-out of the interest rate increase. But that means the credit card issuers will close your credit card. From the discussion earlier, you know what happens to your credit score when a credit card gets closed.
Lower Credit Scores Lead to Fewer Loans
Banks rely so heavily on credit scores to approve new loan applications, but some of their actions cause strong applicants to look less creditworthy than they really are. So when an otherwise creditworthy borrower tries to apply for a loan, they could end up getting denied because of what banks have done to their credit scores.
By closing credit cards and cutting credit limits, banks perpetuate the cycle of limited loan availability and continue the credit crisis.