The Credit Utilization Ratio — A Ticking Time Bomb?

In January 31, 2007

There has been a lot of media attention regarding the recent Congressional hearings on practices of the credit card industry. One of the subjects receiving coverage is the “universal default clause,” which consumer advocates have vocally complained about for years. This insidious provision is buried in most credit card agreements, and it permits a credit card bank to raise your interest rate sky-high if you default on payments to a DIFFERENT company.

I have in front of me a credit card agreement from one of the top ten card issuers. Here is the offending language:

“We may change the rates, fees, and terms of this Agreement at any time for any reason. These reasons may be based on information in your credit report, such as your failure to make payments to another creditor when due, amounts owed to other creditors, the number of credit accounts outstanding, or the number of credit inquiries.”

In plain English, a credit card “agreement” is not a true agreement at all. It’s a totally one-sided practical joke, and the victim is the consumer. Aside from needing an electron scanning microscope to read the fine-print, and a law degree to understand it, the language is totally in favor of the creditor and offers very little protection to the consumer against predatory banking practices.

The universal default clause is bad enough. But it gets worse, and that’s what I want to focus on in this post. Lately, I have been receiving a lot of consultation requests from consumers complaining about steep increases in interest rates, WHEN THEY HAVE NOT BEEN LATE WITH ANY CREDITOR. What gives?

This is a little-known problem, and you don’t hear about it much in the media coverage of credit card practices. While there is some slight justification for placing consumers in a higher-risk category (which results in higher interest rates) if they start falling behind on payments to other creditors, what could possibly justify an interest rate increase when there have been no missed payments to anyone?

The technical concept underlying this industry practice is called the “credit utilization ratio.”

Let’s say you have a total of $30,000 of credit available to you on three different cards, each with a $10,000 credit limit. Now let’s say you are carrying a balance of $4,000 on each card, for a total of $12,000 of debt balances. So far, so good. You are using $12,000 of credit against a total available limit of $30,000, which yields a credit utilization ratio of 40%. As long as your ratio is below 50%, then generally this will not be a problem or negatively impact your credit score. But what happens if you have borrowed $27,000 against the available $30,000 limit? That puts your credit utilization ratio at 90%. While it’s hard to determine the exact ratio that triggers interest rate increases, there’s no question that a 90% ratio will cause problems. The FICO score will probably drop, and worse, the creditors may jack up interest rates to the default rates of 28-32%.

Due to the method by which most banks now calculate minimum monthly payments, the above scenario is a recipe for financial disaster. Let’s say you have been struggling along to make the monthly minimums, even when the interest rates were under control. Most banks now calculate interest rates based on a formula of 1% of the debt balance plus the finance charge for that month. So on a balance of $10,000 at an interest rate of 15%, the minimum payment under this method would be $225. But if the interest rate suddenly jumps to 30%, the minimum payment would jump to $350! Multiply this effect across several credit card accounts, and it’s easy to see why many people are pushed over a financial cliff as a consequence of this practice. Remember, it has nothing to do with being late on any of the accounts. This situation can develop even if you have never missed a single payment! The banks justify this practice by claiming that consumers with high utilization ratios are at higher risk of default. Nothing is said about how the industry practice of raising interest rates actually contributes to an increase in defaults.

So the message is clear. Keep your overall use of credit below 50% of the total amount of credit available to you on unsecured credit cards and loans.



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