The 'Catch 22' of consumer credit

Why you may be damaging your credit scores by not using credit cards.

Renting an apartment, securing a home mortgage, seeking employment, buying a car, even turning on utilities – each of these life experiences will demand a review of your credit history. Nearly 1 in 3 purchases in the United States is made with plastic, or $40 out of every $100, adding to nearly $1 trillion of credit-card debt as of August, according to the Federal Reserve.

Faced with an extended economic recession and a tumultuous global credit meltdown, Americans are finally recognizing the negative consequences of leverage (the number of dollars borrowed for each dollar of wealth). Many people are making a concerted effort to de-leverage by reducing their use of credit cards and adopting a "pay as yougo" philosophy. Abstinence from credit cards has become chic among some younger consumers who have formed Web-based networks to support their pledges of credit-card withdrawal.

Some older borrowers are placing themselves on cash-restricted budgets to reduce their urge to buy. A poll of 1,000 Americans released last week by Consumer Action reported that 69 percent of consumers intend to pay with cash and do not expect to take on additional debt in the next 12 months. Only 1 in 4 had opened new credit-card accounts in the past year.

But Americans' commitment to curb credit-card use has ironically become a Catch-22 scenario: By weaning themselves from credit cards, they actually harm their credit reputation.

Whenever consumers lock up or gleefully cut up their plastic, their credit scores drop as they have increased their credit-utilization ratio. This ratio is determined by dividing a person's total of outstanding debt by their total available credit. As borrowers' credit lines are closed, either by themselves or by creditors, their utilization ratio increases and their credit score decreases, hence the Catch-22.

Ethan Dorhelm, a senior scientist at the company that calculates credit scores, Fair Isaac Corp. (FICO), is sensitive to this problem. "FICO looks at redeveloping its score and making adjustments every two years, reweighting the FICO algorithm to reflect credit trends in the market," he says.

FICO anticipates that by early 2009, one of its three credit models will have been amended to respond to changing consumer credit practices.

Despite efforts by consumers to reduce their debt, credit-card issuers are still cracking down by cutting off inactive accounts and reducing credit lines.

"Credit adjustments are being based on a broader risk-management model," says Ben Woolsey, director of marketing and consumer research for CreditCards.com. "Even if an individual consumer has had no problems of credit-payment deficiencies, if they shop where others who have had a history of default shop, then their credit lines will be reduced."

Consumers are initially left in the dark about these adjustments, notes Linda Sherry, director of national priorities for San Francisco-based Consumer Action.

"Credit-card companies are not providing any notice prior to increasing any of the annual percentage rates or reducing credit lines," she says.

Even borrowers with good credit may face increased interest charges of 2 to 3 percent and reductions in their credit limits. "Credit-card companies are living on borrowed time. The lending practices that they engage in will not be attractive to a new administration," cautions Greg Larkin, senior analyst at Innovest, a Wall Street investment adviser.

To avoid the Catch-22 dilemma, consider the following strategies:

•Charge small amounts on each of your credit cards at least once a month to avoid having credit lines reduced or closed out.

•Enroll in an automatic-payment program to avoid late fees. (Timely payment is 35 percent of your FICO score.)

•Limit credit card use to less than 25 percent of your available credit for each card. (A lower utilization rate is 30 percent of FICO score).

•Don't cancel a credit card you don't use. Length of your credit history is important (15 percent of your FICO score).

•Refuse to open new credit cards despite promotions (10 percent of your FICO score is affected by credit inquiries).

•Diversify your credit to include auto, mortgage, home equity, college, and installment loans. (A credit mix is 10 percent of your FICO score.)

Prudent use of credit cards is vital to your credit reputation. Don't abandon them, but use them wisely.

• Dr. Kathleen Connell is a professor at Haas Graduate Business School, University of California, Berkeley.