How to Blow Your Credit Limit -- Without Spending

If you haven’t had the credit limit cut on your credit card recently, count yourself lucky. Risk-averse card issuers are getting slash happy. And while many cardholders gripe that such cuts slice razor-close to their balance amounts, for an unfortunate few the cuts go far deeper: below what they currently owe.

Under different circumstances, David Chaplin-Loebell wouldn’t have minded that American Express (AXP) cut his unlimited credit line to just $5,000. Except that when AmEx reduced his line in October, he had an outstanding balance of $10,000. “I found out by having a business purchase declined,” he says. Repeated calls to AmEx failed to yield an answer about why the cut was made. Chaplin-Loebell, who lives in Philadelphia, is now paying the balance under his regular card terms, and presumes the line will free up for new purchases once he’s below the limit. “For now, they’ve essentially frozen the account,” he says, leaving him to juggle business expenses on his personal cards. American Express did not respond to requests for comment.

Nasty as it may be, the practice of cutting credit lines below the balance is legal -- at least, for now, says Chi Chi Wu, a staff attorney for the National Consumer Law Center, a consumer advocacy group. Federal Reserve rules requiring lenders to give cardholders 45 days notice before reducing a credit line to the point that it would trigger penalties won't go into effect until July 2010. “[Until] then, there are no federal protections,” says Wu.

Congress is also hoping to rein in unscrupulous credit-card practices. In February, Sen. Chris Dodd (D., Conn.), chairman of the U.S. Senate Committee on Banking, Housing and Urban Affairs, reintroduced the Credit CARD Act, which among other things, offers cardholder protections like the ability to pay under the existing terms if an account is closed and requiring issuers to lower penalty rates within six months once a cardholder gets back on track with payments. In March, the House Committee on Financial Services held a series of four hearings that included discussions about credit card reform.

SmartMoney.com contacted both committees to see if they were aware of issuers’ practice of cutting credit lines below balances, and if they planned to address it in upcoming hearings. Neither responded to requests for comment.

The motivation among issuers to make such deep cuts that they plunge below a cardholder's balance amount isn’t very clear. Usually, issuers cut credit lines to reduce outstanding liabilities -- they sometimes may even chase the balance on riskier accounts with further limit cuts as cardholders pay down debts, explains Bill Carcache, an analyst with investment bank Fox-Pitt Kelton. But cutting below the balance doesn't reduce an issuer's liability: The cardholder still owes the outstanding debt.

One possibility is that this is yet another attempt by card issuers to get consumers to close their accounts (while bringing in a little fee income in the short term), says Dennis Moroney, research director and senior analyst for consulting firm Tower Group. “I can’t rationalize in my mind what other motivation there would be,” he says.

Paul Pensabene of Saratoga Springs, N.Y., received a statement from HSBC on Dec. 8 that said he had a $359.99 balance and remaining available credit of $8,640. But when he went online to pay the bill several days later, his online account showed that same balance put him over his newly-reduced credit line of $300. And that didn't include the $35 over-limit fee. Pensabene grappled with customer service until they agreed to remove the fee, and then paid the balance in full. “All I could think was, ‘Good lord, what if this is happening to someone that couldn’t pay their balance off in one shot?’” he says. “They’d end up in default with these fees piling up.”

HSBC declined to comment on individual cardholder accounts. Spokeswoman Cindy Savio says the issuer has tightened its credit standards based on the economy. “As we have previously stated, in an effort to reduce credit risk and refine strategies for our card business, we have tightened credit standards, reduced or canceled higher risk credit lines, and closed a number of inactive accounts,” she says.

While the fees, frozen accounts and default interest rates resulting from credit-line cuts can sting your finances, they can do some serious long-term damage to your credit score. Your credit utilization ratio -- the total amount of debt you owe in relation to the amount of credit available to you -- accounts for roughly 30% of your score. A credit line cut has the potential to decrease your score by 50 points or more if you don’t have much other available credit, says Craig Watts, spokesman for FICO (FIC), the company that calculates and issues the credit score that most lenders use.

Even cuts that are close to the balance have the potential to devastate if they’re not caught quickly. Luckily for Carol Gressett of Decatur, Miss., she noticed the reduction in her Discover-branded Sam’s Club card limit just days after it happened. The limit was cut to within $100 of her $3,000 balance. The official letter notifying her of the reduction arrived three weeks later. “We could easily have gone over if I hadn’t been paying attention,” she says.

(A Discover (DFS) spokesperson says GE Money issues the cards, and so is responsible for managing credit lines. GE Money did not respond to requests for comment.)

For more on our series about credit-card issuers' recent moves, read: