First Time Home Buyer

The fallout from the subprime mortgage crisis now includes another unintended consequence: credit card companies are reducing borrowing limits for tens of thousands of consumers, which then can lead to lower credit scores. This is hitting first time home buyers especially hard.

This is a direct result of the financial world’s widespread effort to minimize exposure to risk. Banks and other card lenders are actively taking steps to protect themselves from immense losses like those they’ve experienced from subprime mortgages.

As credit card default rates start to creep up, credit card lenders are lowering credit limits, which means they are reducing the maximum amount of credit extended to an individual. The American Bankers Association, a Washington-based trade group, states that, in general, credit card lenders are worried that consumers who are faced with a number of ugly economic scenarios hitting at the same time - falling home prices, surging food and energy costs and a weak job outlook - won’t be able to pay their bills.

And lower credit limits are definitely hurting credit scores. This is how it happens: Let’s say a person has a credit card with a limit of $8,000 and is carrying a balance on the card of $2,000. The credit card company worries that large balance may increase the prospects for default, so it lowers the credit line to $2,500.

But in doing so, it drastically changes what is known as the credit utilization rate, an important element in the formula that determines a person’s credit score. In this example, the credit utilization rate has gone up from 25 percent to 80 percent. That is then factored into the calculation of one’s credit score. Craig Watts, a spokesman for Fair Isaac Corporation, confirmed that the credit utilization rate is an important factor in determining a person’s credit risk. The FICO scores, which aim to measure the credit risk of an individual, are the most used credit scores in the world.

The Comptroller of the Currency, one of the government agencies that regulate U.S. banks, requires credit card companies to notify cardholders at least 15 days in advance before making changes in the terms of their account, such as lowering the credit limit. While consumers cannot prevent credit card companies from lowering their credit limit, they can prevent their credit scores from suffering as a result. Simply pay the credit card bill in full every  time you receive a statement and do not carry an balance from month to month. Better yet, only use credit cards in an emergency situation. That will bring benefits in more than one way: you will not have to pay any interest, you’ll help boost your credit score as high as possible, and you’ll preserve your borrowing power.

That’s not what the credit card companies want, but it is definitely in your best interest to do so.

For the first time since the subprime mortgage crisis began last summer, the Federal Reserve left their key interest rate unchanged at a low 2%. Unclear whether a slowing economy or growing inflation was a greater threat to the financial well-being of the nation, policymakers decided to wait for the effects of 10 months of lowering interest rates to be felt. They also issued a statement saying they’d be on guard against both economic decline and an inflationary price surge.

While today’s mortgage rates will not be affected, in the coming months if Fed Chairman Ben S. Bernanke and his colleagues are forced to tackle inflation, they may have to crank up rates much higher than they would if the problems were entirely domestic. Rising food and energy costs are not just limited to the United States. Those price increases are being felt across the globe.

However, rising inflation expectations are a special worry for central bankers because they signal that people have begun to assume that prices are on the way up and therefore that they should charge more for their labor or products. That is a recipe for setting off a vicious cycle of higher prices feeding still higher ones. Once inflationary expectations set in, it is a difficult process to stop.

The Federal Reserve routinely speaks of managing inflationary expectations. If the public believes that higher prices are here to stay, people will begin charging more for their labor or products. Thus the Fed tends to lean towards issuing statements that are slanted towards not only moderating inflation, but also that high prices will be coming back down.

Real world events of the past few years are completely opposite of the Fed’s forecast for moderating inflation. The price of oil has risen nearly seven fold from a low of about $20 per barrel in 2002, to a high near $140 per barrel today.

Federal Reserve policymakers are hoping that as long as the public believes the Fed will act to control inflation, today’s price increases are unlikely to feed tomorrow’s wage claims, and a wage-price spiral can be averted.

However, prices have risen significantly, even if inflation expectations haven’t. The problem is that consumers need higher wages just to match the price rises of the past few years. Until consumers’ income can catch up with rising prices, economic recovery will be elusive.

But for now, first time home buyers can enjoy low rates. Our mortgage rates predictions are for rising interest rates because of rising inflation - a forecast that is directly at odds with the most powerful central bank on Earth.

Which forecast will prove to be more accurate? Only time will tell.