Listener Kaitlyn asks: How will canceling a credit card affect my credit scores? Money Girl Laura Adams explains what you need to consider before closing an account, how to minimize hits to your credit, and tips for canceling cards strategically.
Kaitlyn O. says, “I'm a big fan of the Money Girl podcast and have been listening for years! A while ago, I racked up substantial credit card debt. So, I opened a balance transfer credit card and worked hard to pay it all off within the 0% APR period, which worked out great.
However, now I'm stuck with a super basic credit card that doesn’t offer any rewards. While I don't want to waste time with this card, I'm also really nervous about closing it and messing up my credit score. I'm thinking about closing it and requesting a credit limit increase on another card I have that pays rewards. What do you think about that strategy?”
Thanks so much for your question, Kaitlyn! As you mentioned, managing credit cards properly is an essential part of building excellent credit. Many people mistakenly believe that closing credit cards automatically improves their credit. But the opposite is true because canceling credit accounts can instantly damage your credit.
But that doesn’t mean it’s never a good idea to close a card. This post will review what you should consider before canceling a credit account, how to minimize hits to your credit, and tips for closing credit cards strategically.
Why having good credit matters
Before we get into the pros and cons of canceling credit cards, let’s take a step back and review why having good credit matters in the first place. Many people don’t understand that credit affects multiple aspects of your financial life. Please don’t listen to anyone who tells you that credit doesn’t matter.
Most people know that having good credit allows you to get the most competitive interest rates and terms on credit accounts, such as credit cards, mortgages, car loans, and personal loans. For example, paying 1% less for a 30-year, fixed-rate mortgage could save you over $100,000 in interest, depending on the total amount borrowed and how long you own the home.
However, even if you never borrow money to finance a home or car, or you choose not to use credit cards, having good credit improves your finances in the following ways:
• Reducing your auto insurance premiums (in most states)
• Reducing your home insurance premiums (in most states)
• Offering more rental housing opportunities
• Cutting required security deposits on utility accounts
• Making you eligible for more government benefits
• Making you more attractive to potential employers that check credit (in most states)
The only way to build credit is to have active credit accounts in your name and use them responsibly over time. Your transaction data typically gets reported to at least one of the three nationwide credit bureaus: Equifax, Experian, and TransUnion. The information in your credit files gets used by various credit scoring models to calculate your scores.
Having no credit is the same as having bad credit because it doesn’t give a creditor or merchant enough information to know if you handle financial obligations responsibly.
If you don’t have any credit data or good credit history, you could get denied a loan, credit card, benefit, or rental because you have a “thin” credit file. In other words, having no credit is the same as having bad credit because it doesn’t give a creditor or merchant enough information to know if you handle financial obligations responsibly.
How canceling a credit card hurts your credit
Now that you understand some of the ways credit helps or hurts your financial life, let's talk about how it relates to canceling credit cards.
One of the most significant factors in calculating credit scores is how much debt you owe, including a variable called your credit utilization ratio. It's a formula that compares your debt on revolving accounts, such as credit cards, retail cards, and other lines of credit, to your available credit limits on those accounts. And the lower your utilization rate, the better.
Here's how to figure your utilization ratio: Add up your revolving debt balances and divide that number by the total of all your credit limits. Don't forget to include balances you have on any employer-issued credit cards in your name because they also get reported to your credit files.
To double-check what accounts are in your name, how much you owe, and your credit limits, look at your credit reports. You can get free report copies and scores at sites such as Credit Karma and Credit Sesame.
Let’s say you have two credit cards that each have credit limits of $1,000. If you owe $500 on one card and $0 on the other, your utilization would be $500 divided by $2,000, or 25%, which is a good ratio. Make a goal to keep your credit utilization below 20% to 25%.
When your credit utilization goes up, you appear to be a greater credit risk, which causes your credit scores to go down. The idea is that if you can’t pay down your balances, you must be spending too much and may even be close to defaulting on your debts.
Getting back to my example, consider what happens if you cancel the card with a $0 balance and a $1,000 credit limit. You might want to close the card because you’re not using it, you finally paid it off, you don’t want the temptation to use it, or you’re like Kaitlyn and don’t like a particular card anymore. Once you cancel the card, your utilization ratio drops significantly because your available credit limit gets cut from $2,000 to $1,000.
Closing a card is most detrimental to your finances when you plan to buy something expensive, such as a home or car, soon.
Now, your revised utilization ratio math is $500 divided by $1,000, or 50%. Even though you have the same amount of debt, your utilization ratio skyrocketed from 25% to 50%. Like it or not, closing the card makes you appear less credit-worthy, and your credit scores plummet.
So, canceling a credit card hurts your credit because it instantly lowers your available credit limit, spiking your utilization ratio. Closing a card is most detrimental to your finances when you plan to buy something expensive, such as a home or car, soon. Jeopardizing your credit could ruin your ability to get a competitive, low-rate loan and cause you to overpay interest for decades.
When canceling a credit card is a good idea
While there’s no way to avoid some negative credit consequences when you close a credit card, there still may be a good reason to do it. For instance, I don’t recommend you have any credit accounts that tempt you to overspend or make impulse purchases. Taking a temporary hit to your credit might be well worth it to prevent more significant problems in your financial life.
Before closing a card, consider the answers to the following five questions:
1. Will I need new credit soon?
As I mentioned, if you’re planning to buy a home or finance a vehicle or other big purchase in the next 3 to 12 months, I don’t recommend closing a credit card. If your utilization ratio increases and your credit scores dive, you could be turned down or offered an expensive loan.
2. What’s the card’s credit limit?
The lower a card’s available credit limit, the less it could negatively affect your credit when canceled. For instance, Kaitlyn didn’t mention the limit on her card, but if it’s more than $1,000, I’d lean toward keeping it rather than closing it.
Kaitlyn mentioned simultaneously requesting a credit limit increase on another card to offset a cancelation. That's a great strategy to ensure you don't hurt your credit or boost it if you keep all your accounts in place. I'd make sure a credit limit increase is successful before moving forward with account closure.
3. How long have I owned the card?
In addition to making payments on time and keeping a low credit utilization ratio, the length of time you’ve had accounts in your name is an important credit scoring factor. Having a long, rich credit file boosts your scores and makes you appear less risky to potential creditors. That’s one reason why it takes time for young people to build credit.
Note that closing a card doesn’t make it disappear from your credit history. So never cancel a paid-off credit card with negative information, such as late payments or being in collections, thinking that it will vanish from your credit reports.
Credit accounts remain in your credit files for 10 years—unless they contain negative information, such as late payments. Any credit accounts with black marks only stay on your credit history for 7 years.
Once the 10- or 7-year period expires, a closed or paid-off account will fall off your credit reports. But that may cause your average length of credit history to decrease. Therefore, it's better to keep a card you've owned for many years open, especially if it has a positive credit history.
A common dilemma is what to do after opening a card you got pressured into at a retail store. Sometimes salesclerks make getting a considerable discount with a new card signup sound too good to pass up. In some cases, you may not even realize that you're signing up for a credit card.
If you’re loyal to a store and make frequent purchases there, having its branded credit card could save money, making it worthwhile. While you can’t erase a card that you opened by mistake from your credit history, if you’d rather not have it, closing it sooner rather than later is better for your credit.
4. How many credit cards do I have?
If you have lots of credit cards, closing one with a low credit limit that you haven't owned very long won't hurt your credit too much. However, if you want to close multiple cards, it's best to space out cancellations every 6 months.
Another credit scoring factor is whether you have a mix of credit types, such as revolving credit and installment loans. Creditors want to know that you can handle different types of credit.
So, if you only have one credit card, it's best to keep it. You need at least one credit card in good standing. Some experts even recommend having several cards from different issuers, such as American Express, Discover, Mastercard, and Visa, for optimal credit.
Another tip is that most credit scoring models calculate your utilization ratio for each of your revolving accounts and collectively on all your accounts. So, it's better to spread out your balances on multiple cards and maintain low utilization on each card than to max out one card.
In How Many Credit Cards Should You Have for Good Credit, I cover how to know what number of credit cards is right for you.
5. What does the card cost?
If you have a card that charges an annual fee, you might be itching to close it. However, if it’s a rewards card, consider if you could be getting more from it, such as cash back, airline miles, or points for merchandise. Sometimes the potential rewards are worth much more than the fee if used wisely.
However, if you can’t afford the annual fee or know that you won’t use a rewards card to your advantage, you may want to close it strategically, using the tips provided here. Consider getting an offsetting credit limit increase on another card or applying for a new card that you would use to avoid damage to your credit.
How to manage unused credit cards
If you or Kaitlyn decide to keep a card that you don’t like or use very often, it’s best not to ignore it completely. If you don’t use a card for an extended period, an issuer may decrease your credit limit or inactivate the account. So, consider using it to make a small purchase at least a few times a year to ensure it stays active. That allows you to continue adding positive information to your credit history.