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How cutting credit limits hurts cardholders, the economy

Fred Williams

About a third of U.S. households do something that looks irrational to economists. They keep money in the bank, earning next to nothing, while they also carry a sizeable balance on credit cards.

Economists call it the “credit card puzzle.” The average APR on cards that carry a balance is about 13 percent, according to the Federal Reserve. So the smart move would be to pay down card balances with savings.

Scott Fulford, an economist at Boston College, has studied the puzzle, and thinks he’s unlocked the solution. In a working paper published by the Federal Reserve Bank of Boston, Fulford says people keep extra savings on hand because they can’t depend on credit to be there when they need it.

How cutting credit limits hurts cardholders, the economy

“It turns out that credit limits vary a lot,” Fulford, a visiting scholar at the Boston Fed’s Consumer Payments Research Center, said in an interview. The Fed’s access to a trove of Equifax credit report data let him study credit limits in ways that haven’t been done before. “It’s actually pretty easy to have your credit cut,” he said.

If you look up Chase Sapphire’s card agreement, it says the company may “cancel, change or restrict your credit availability at any time.” Discover says it may “increase or decrease your account credit line or your cash advance credit line without notice.”

Most cards have similar language, a search of agreements on file with the U.S. Consumer Financial Protection Bureau shows. It is boilerplate that cardholders probably skip over. But it is a big reason why an unused credit limit is no substitute for money in the bank.

Having your limit cut is not an idle threat. Available credit on cards peaked at $3.7 trillion in late 2008 — then it plunged by more than $1 trillion in just two years, according to the Federal Reserve’s credit report data. It’s still about $760 billion below the 2008 record.

Some of that spending power vanished because consumers closed cards voluntarily. Some of it disappeared when banks shut off cards for default. And a chunk of it went missing because banks dialed back limits to reduce their risk, Fulford’s research indicates. People with good credit scores had their available credit cut, as well as people teetering on the financial edge.

A cut can be innocuous, or a rattling financial blow. If an old J.C. Penny card that you forgot about is closed, that’s one thing. But if the limit drops on a general purpose card, your cushion for emergencies is thinner. Letting charges for gas and groceries carry over a month might not be an option. And those convenience checks the bank sent you in better times lose their power to cover financial emergencies like a dead transmission or a leaking water heater.

Fulford figures it costs the average household $30 a month to hold onto savings while also carrying a balance. That adds up, but it’s not a ticket to bankruptcy court.

There’s another problem with vanishing credit limits, however. Banks want to hunker down when the economy turns south, and clamping down on credit card limits is an easy solution. When banks pull the credit cushion away, households — even economically healthy ones — spend less and save more. That deepens the economic downturn, as companies lose sales and lay off more workers.

“A lot of this tends to happen all at the same time,” Fulford said.

One possible solution is to make limits on credit cards more dependable, he suggested. With home equity loans, for example, the amount of credit is set by contract. The limits are reviewed periodically, but they don’t suddenly evaporate.

But if you tell banks they can’t cut credit lines, wouldn’t they just offer fewer cards, with lower limits?

“It’s hard to figure out how [banks] would react to such a policy,” Fulford said, explaining that he’s not necessarily advocating new rules. But considering the importance of credit, he added, it wouldn’t hurt to think about ways to make it more dependable.

For most households, the available credit on credit cards is the biggest source of buying power. Fulford’s paper, titled “How important is variability in consumer credit limits?” puts it this way: “In the short term, credit is the primary determinant of how much households in the U.S. can spend, not income or savings.”

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