Does Canceling a Credit Card Hurt Your Credit?
Get tips about closing a credit card and whether it can hurt you.
The last two shows have been about credit cards--the right strategy for paying them off and how to use a balance transfer card to your advantage. But what happens after you achieve the goal of paying off a card? In this show I’ll discuss whether you should close a credit card account or not.
Should You Cancel Your Credit Cards?
After you pay off a regular credit card or a balance transfer card, the next logical question is what to do with it. Maybe you have another credit card, or two, so canceling one seems like a good way to simplify your financial life. Or perhaps you really struggled to pay off a card that you used too freely in the past. Now you’re determined to close it so you don’t get lured into the trap of overspending again. Those are both very good reasonss to cancel a credit card.
Can Canceling a Credit Card Hurt Your Credit?
But before you do it, you may be surprised to hear me say that there are actually some good reasons not to do it! Canceling a credit card can hurt your credit score. To understand how that’s possible, I need to explain a bit about how your credit score is calculated.
There are different credit scoring models that exist, but you’ve probably heard of the one used by most lenders--the FICO score. FICO stands for the Fair Isaac Corporation and you can find more information about it at myfico.com.
Five Factors that Affect Your Credit Score
According to myfico.com:
- The factor that influences your credit score the most is your payment history. Whether you’ve been naughty or nice to your creditors makes up 35% of your score. So remember to pay all your bills on time.
- The second most important variable is the number of accounts you have and how much you owe on them. That makes up 30% of your score.
- The third most important factor is the length of your credit history. Having long-standing credit accounts is important and can make up as much as 15% of your score.
- The fourth factor is the number of recently opened accounts and recent credit inquiries. Having too many inquiries can jeopardize up to 10% of your score.
- And the fifth factor is the final 10%. It’s the number and types of accounts that you have, such as credit cards, auto loans, mortgages, home equity lines of credit, and retail accounts, for example. Having a mix of credit positively affects your score.
So let’s discuss how the simple act of canceling a credit card can reduce your credit score. You’d think that canceling a credit card would be one less account on your record, right? Well, the problem is that a card cancellation negatively affects three of the five credit factors that I mentioned. The biggest issue is something called “credit utilization”.
Keep a Low Credit Utilization Ratio
Credit utilization comes into play with the second factor--the number of credit accounts you have and how much you owe on them. Your credit utilization is expressed as a ratio of your credit balances to your available credit limits; it’s also called a debt to credit ratio.
Let me give you an example. If you have a credit card with a $4,000 credit limit and your balance is $1,000, you’re using 25% of your available credit. To calculate your credit utilization for any credit account, simply divide your current balance by the credit limit. For my example, the calculation is $1,000 divided by $4,000, which equals 0.25 or 25%.
There’s no specific ratio that FICO or the credit bureaus recommend, but the lower you keep your credit utilization ratio, the better. Many experts propose that you use 30% or less of your available credit to optimize your credit score. Any time your available credit limit is reduced, it increases your utilization ratio, which can negatively affect your credit score. So canceling a card--even one that’s paid-off--leaves you with less available credit. That increases your utilization ratio and causes your credit score to drop.
An important quick and dirty tip is to never max out all your available credit lines, even if you pay off your balance in full each month. It’s better to have two credit cards that each have balances below 30% of your credit limits than to have one card that you consistently max out. Keeping a good cushion of available credit can raise your credit score.
Don’t Cancel a Card with Lengthy Credit History
Another issue to consider before you cancel a credit card is how long you’ve had it. Your credit history is the third most important factor in the calculation of your credit score. Canceling a long-standing credit card shortens your history, which could be an additional injury to your credit score.
Don’t Cancel Your Only Credit Card
The last reason I’ll give you not to cancel a credit card is that you need a healthy mix of credit accounts. As I mentioned, that makes up 10% of your credit score. If you cancel your only credit card, that would leave you deficient in the revolving credit category.
Weigh the Credit Card Pros and Cons
It’s important that you weigh the pros and cons of canceling a credit card for yourself. I certainly discourage you from having a credit card if you wouldn’t use it wisely. If you can tuck it away and use it only for emergencies, that’s great. But if the temptation to use it would still be there, one solution is to keep the account open for the sake of your credit score, but to shred the card.
For more Money Girl advice regarding credit scores, check out these episodes and tips:
- How to Raise Your Credit Score Fast
- An Easy Way to Build Your Credit Score
- Where to Get Your Credit Score
- What Affects Your Credit Score the Most?
- Don't Let Inquiries Lower Your Credit Score
I’m glad you’re listening. Chi-Ching, that's all for now, courtesy of Money Girl, your guide to a richer life.
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