Credit utilization, a significant factor in deciding credit score - Time to look beyond

Introduction:

Credit utilization plays a major role in deciding the credit score. The long running practice, which needs a serious look so that it plays a balanced role among deciding credit rating and reducing credit card payment fraud and ever increasing NPA on credit card loan and payment default. Traditionally 20-30% of credit utilization of a credit card limit is considered a good financial practice and credit card users, whose credit utilization falls in the above-mentioned bracket usually fall in the right bracket of credit scoring method - means higher credit score. Normally a higher credit score increases chances of getting loans approved in the future. On the other hand, the remaining unutilized credit amount of the credit card is a major factor in contributing the yearly increment of the credit card fraud amount.

Credit card and NPA:

The Covid-19 has pushed the world economy to the brink. Across the globe, the banking industry is expecting a higher default rate. As per the latest Quarterly Report on Household Debt and Credit, published by the Federal Reserve Bank of New York, The US credit card debt balance was $0.79 trillion at the end of 2021Q2. India’s largest public sector bank, the State Bank of India has seen its card and payment sector NPA has doubled to 4.29% during the third quarter of the year 2020. It was an increase even though there was a (August 2020) moratorium period of 6 months, advised by the Reserve Bank of India.

Credit card and credit fraud:

According to a CNBC report published on 27th January 2021, it was estimated that by the end of 2020, the U.S. was staring at about $11 billion worth of losses due to credit card fraud.” It was also highlighted that the coronavirus pandemic will simply increase this number. The USA was reported as the highest credit card fraud prone country with 38.6% reported loss in 2018. With the increase in e-commerce business, the percentage of occurrence of the “Card-not-present” fraud is increasing every financial year. Due to current law and regulations, the consumers are mostly protected from unauthorized transactions made with their cards. The card issuers and merchants bear the brunt of the credit fraud. So far it is observed that primarily issuers pay a major portion of the loss.

There are certain limitations, which also play a major part in the recent surge in credit card payment fraud. With the proliferation of digital technologies, the fraudsters are better equipped to commit fraud. Whereas financial institutions have provided users options to restrict their daily credit card transaction limit, this functionality is still not widely utilized. Even if card users opt to leverage this functionality, still they are vulnerable when card details are stolen or cloned.  Another concern is about no usage of OTP for any international transaction. This is the major headache for the card issuer and merchants.

 So, the prevalence of card fraud raises serious questions about the influence of lower credit utilization in deciding credit score.  It is time, Financial institutions and credit score agencies do look at the existing scoring method and find out which one outweighs which one, cumulative benefits of higher credit score for both card holder and issuer due to low credit utilization or credit card fraud generating due to higher credit limit or Credit default number is piling up due to higher credit limit.

Credit card consumers insight:

It is not tough to find out the spending habits of an individual. Banks and Financial institutions are equipped with enough data, and modern technology, which can comprehensively predict a user’s monthly spending pattern. The card issuers can easily classify the credit card consumers based on their spending pattern.

1. Someone, who is applying for a credit card for the first time, tends to have a low credit score due to low credit age.
2. Unlike the first-time applicants, the affluent users always outsize the weight of spending volume than any other group of credit card consumers. Major portions of credit card spending are carried out by these affluent users. So, card issuers might go for a very conservative and steady approach instead of sudden rapid changes, which might cause complete disruption of the revenue flow.
3. For a user who had two cards and has given up one, the burden shall fall on the other card. There must be a seamless mechanism to optimise the credit limit based on spending patterns. Similarly, when a user is switching from single multiple cards, the limit allocation for each card should also be based on spending pattern and credit quality.

Conclusion:

Set the credit card limit according to an individual’s spending pattern and cap it to not beyond 10-20% of the average monthly expenditure. Also card issuers should keep an eye on the credit behavior of the credit card holder. When financial institutions switch from fixed credit limit to dynamic credit limit, they are better off in terms of NPA. Also, fraudsters do not get a free pass to take advantage of the high delta amount, which is the difference between credit card limit and utilized credit limit. Moreover, financial institutions can come up with a strategy that allows consumers to have the option to use extra credit amounts specially during special times of the year such as Christmas, Thanksgiving Day, Diwali, or Ramadan etc. At the same time, when situations such as any financial crisis happens, Financial institutions must have liberty to reduce the credit limit. That said, credit score agencies must not punish card holders for using almost the total credit limit without any credit default history. Instead they should rewarded for judicious planning and utilization of their credit limit. Otherwise the writer’s view will be counterproductive.

Acknowledgement:I would like to send my sincere thanks and recognize the assistance, invaluable feedback and contribution that I received from Partha Pratim Ghosh (https://www.linkedin.com/in/partha-pratim-ghosh-7730259/) to complete this blog.