Don’t Make Credit Decisions Based On Last Year’s Recommendations!
Jan 11th, 2009 | By Rob | Category: debt
When I was taking a political science class in college, we learned about the problem of “fighting the last war.” If you’re successful in fighting the last war, you will continue to prepare as you always have and may ignore important changes to the battlefield that change your prospects for winning the next war. It’s hard to prepare to fight the next war, since you are not sure what that war will look like, and your past success makes it difficult (and risky) to throw out what has worked in the past. But if your opponent is ready to fight the next war and you are not, you may quickly find that your calculations about success when considering entering the war are way off.
That’s how I feel about the advice of many newspaper columnists on credit card debt currently. They may be right, if the conditions have not fundamentally changed from the past five years. On the other hand, credit conditions have changed so much over the past year that it is possible that their advice is preparing you to fight the last war and not the next one.
The Chicago Tribune published a recession survival guide recently, and one of its articles on how difficult it has been to get and keep credit starts off with two problematic recommendations:
1. Don’t run up bigger balances on your credit cards than you have in the past.
2. Keep outstanding balances below 50 percent of your credit line.
Why are these recommendations dangerous? Not two paragraphs later, the article details a family that had $40,000 to $50,000 left on their home equity line and received a letter in August that their credit line was frozen at the amount that they had currently borrowed. If they had drawn down their line of credit when it was available, instead of keeping their outstanding balance below 50 percent, then the family would have had cash in the bank to weather the bank’s decision to terminate further lending.
The Wall Street Journal also has a recommendation article that would have made sense over the past five years but now seems to miss the point of the credit crisis. If your credit card provider lowers your credit limit, their first recommendation is to call up your credit card company and ask for a higher limit. Their point is that a good customer has leverage to take their business elsewhere.
While it’s a low cost option to fight the lowering of a credit line by asking the bank to reconsider the decision, there’s two problems. First, as the earlier cited Chicago Tribune article points out, “Finding new credit or just holding on to what you have has gotten extremely difficult.” If you don’t have adequate credit open such that you have to ask a bank that has lowered your credit card limit to raise it, then your leverage from your ability to take your business elsewhere is almost nonexistent. And my presumption is that the banks know it. They are on the front lines of the credit crisis, after all. Second, the bank has, in some ways, just made a determination that you are a credit risk when they decrease your line of credit. Asking them to reconsider their decision without new evidence of your credit worthiness seems a tough sell.
Given the current environment, the recommendation only makes sense under two conditions. First, if the bank has simply reduced your access to available credit as part of a decision to protect its own capital reserve, the bank may be willing to reopen some of your creditline if it subsequently finds that it has reserves to spare (or built in a cushion to increase the credit line of some consumers who complain). And second, it’s a free shot at getting the bank to change its mind. Otherwise, it’s hard to believe that it’s practical advice.
A quick look at how businesses are responding to the credit crisis shows another response to the credit crisis that differs remarkably from the advice given to consumers: businesses are drawing down their revolving credit lines, according to this Investor’s Business Daily article. A revolving credit line is like a business credit card. Either because businesses are afraid of having their credit line cut or they are afraid of not having enough cash on hand in this credit environment, many businesses are drawing down their credit lines and giving themselves an insurance policy against credit problems.
While I’m not recommending that everyone run to the banks and pull cash off their credit cards, putting some cash in your savings account with a balance transfer to draw down your credit line and give yourself a bit of an insurance policy is at least as sensible in the current economic climate as continuing to pay down your credit card in the hope that the credit provider won’t see you as a credit risk and cut your line of available credit.
This is just a reminder that you should evaluate your financial position according to the current economic climate and not the environment from last year. There is a certain amount of wisdom in the way that businesses have reacted to the recession, bolstering their cash positions and drawing down on credit that may not be available in the future. While this is a business calculation for everyone to make, when you decide to pay down your credit card debt and pray that the banks take pity on you and don’t decrease your available credit, you should be sure to ask yourself whether you are fighting the last war, or the next one.
Great post - thanks. It’s interesting the way that the lending sector still isn’t sure what it’s saying or doing - and certainly here in the UK it is using taxpayers’ bailouts to award “performance” bonuses …
Keep up the great work!