As credit lines are slashed, recovery could stall

Banking analyst Meredith Whitney sees the writing on the wall: credit card companies are cutting credit lines of worthy borrowers, which could hurt the U.S. economy and stall recovery. As even worthy consumers see their credit lines slashed, less and less credit will be available for spending. With lower credit limits, credit scores go down and even fewer people will be able to get credit to buy homes and cars. How can businesses start to turn around if no one is able to buy their products?

Whitney wrote in the Wall Street Journal that, "Few doubt the importance of consumer spending to the U.S. economy and its multiplier effect on the global economy, but what is under-appreciated is the role of credit-card availability in that spending."

Whitney says that available credit lines were reduced by nearly $500 billion in the fourth quarter of 2008 and she expects over $2 trillion dollars in available credit will be cut in 2009 and a total of $2.7 trillion will be cut by the end of 2010. That's a cut of more than 50% of available credit, which is about $5 trillion right now.

Consumers know (or should know) that to keep a top credit score they can't use more than 20 percent of their available credit. By cutting credit lines so drastically, banks are forcing people to debt utilization ratios closer to 50 percent. That will send credit scores plummeting. Right now, if a consumer doesn't have a score of at least 720, that consumer needs 20 percent down to get a mortgage because she'll have difficulty getting private mortgage insurance or will have to pay a much higher interest rate for the life of the loan. (However, some FHA loans are still available to people with less than 20 percent down.) Overall, forcing people's credit scores below 700 could stall the recovery of the housing industry.

While there is no doubt people have gotten in trouble using credit cards, the ones who will be hurt by these drastic credit line cuts will not only be those who used credit poorly, but also those who manage credit well. Many people with credit scores over 720 are seeing their credit lines cut and interest rates increased by the same banks who are getting bailed out by the government. Those moves are working against economic recovery.

Over the past 20 years, Americans have used their credit cards as cash-flow management tools, but 90 percent of credit card users revolve a balance at least once a year, Whitney said. As much as 45 percent pay off balances in total each month.

While it's true credit card defaults are rising, cutting credit lines as drastically as Whitney suggests is going to happen is an overreaction to the problem. Banks must find a better way to recognize debtors is trouble rather than do a blanket cut of all available credit for good customers as well.

Lita Epstein has written more than 25 books including the Complete Idiot's Guide to Improving Your Credit Score.

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