What Do the Debt Ceiling and Credit Limits Have In Common?

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With all of this talk about debt ceilings and a governmental default, I figured it's a good time to cover the story with a non-political angle. That's right, there is a way. Let's talk about credit limits.

But first things first: what is a debt ceiling? A debt ceiling is a fancy way of describing our country's upper limit of borrowing authority. The U.S. Constitution gives Congress the right to borrow money on the credit reputation of the United States. And while the coverage of the debt ceiling is relatively recent, it's been around for almost 100 years.

If this sounds similar to consumer borrowing limits, or credit limits, it should. In this case, the consumer acts as the U.S. Congress and a lender, usually a credit card issuer or home equity line of credit (HELOC) lender, sets the upper borrowing boundary, or credit limit. Credit limits are limited to credit cards, charge cards, HELOCs, gas cards, and retail store card.

Some will argue that charge cards don't have a pre-set credit limit, and they're partially correct. Charge cards don't have published credit limits, but they do have what's referred to as a “shadow limit.” If you don't believe me, try buying your next car using a charge card.

Lenders assign credit limits by assessing two things: credit risk and potential profitability.  The riskier the borrower, the lower their credit limit is going to be.  And, conversely, low risk borrowers are almost always going to have access to more capital, in this case in the form of a generous credit limit.

Limits on HELOCs are assigned based on the amount of equity you have in your home.  Equity is the difference between what you owe on your mortgage loan (or loans) and the appraised value of the house. If the house is worth more than the aggregate amount of the loans secured by it, then you have positive equity. If, however, you owe more than your home is worth, you have negative equity. Your humble author is enjoying negative equity in his home as you read this.

The credit limits on your credit cards are usually reported to the credit reporting agencies. And while they are very important to the usability of the card, they are even more important to your credit scores. The closer the balances are to your credit limits, the lower your credit scores will be. It's that simple.

Because of the sharp drop in property values since 2007, many consumers saw their HELOCs suspended. Until 2007, a HELOC was generally a fully secured loan, meaning that any outstanding balance would be fully covered by the home's value. When values dropped, many lenders realized some of the HELOC loans were high risk and partially (or fully) unsecured.

Now let's go back to the debt ceiling issue. The U.S. Government doesn't have a credit score. They, instead, have a credit rating issued by rating agencies (Standard and Poor's, Moody's and Fitch Ratings). For all intents and purposes, the ratings issued by these agencies are pretty similar to consumer credit scores: they are used to set interest rates on money that we, as a country, choose to borrow.

Now, some people have hinted that our debt is a bigger problem for our credit rating than any issue with the debt ceiling. And if you believe the research findings that prove excessive debt equates to credit risk, which is very true, then you'd have to conclude that we're still very risky, as a country, despite the fact that we're not going to default on our obligations.

It's still very possible, however, that our country's credit rating will be reduced from “AAA” to some other less attractive rating. In fact, there are some people that are suggesting that if the rating agencies don't downgrade our credit rating, they're as out of touch as they were when they were grading horribly risky mortgage backed securities as AAA.  That, of course, was the cornerstone cause of the current credit crisis.

Stay tuned as this story's ending has yet to be written.

John Ulzheimer is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO and Equifax, John is the only recognized credit expert who actually comes from the credit industry. He is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a Contributor for the National Foundation for Credit Counseling. Follow him on Twitter here.