Not sure if you should cancel a credit card? Laura answers a listener question and gives you five questions to ask that will help you know whether closing a credit card will barely affect your credit scores or end up hurting your finances.
The Relationship Between Credit Cards and Your Credit Scores
Your credit utilization, or how much of your available credit you use, is a critical factor in how your credit scores are calculated. It applies to revolving accounts, which don’t have a fixed term, such as credit cards and lines of credit. Credit utilization doesn’t apply to fixed loans—like the kind you get for a car or home—that have an ending date.
Credit utilization is a simple formula that equals your total account balance divided by your total credit limit. For example, if you have a credit card with a balance of $1,000 and a credit limit of $2,000, your utilization ratio is 50% ($1,000 / $2,000 = 0.50).
Keeping a low utilization, such as below 20%, is optimal for good credit. So, by paying down your balance on the card to $400, you could reduce your utilization ratio to 20% ($400 / $2,000 = 0.20) and boost your credit scores.
If you have more than one line of credit or credit card, most credit scoring models calculate your utilization ratio for each account and collectively on all your accounts. So it’s better to spread out your balances on multiple cards and maintain low utilization on each of them, rather than have one card that you charge to the limit.
A low utilization ratio says that you’re using credit responsibly. A high ratio indicates that you may be maxed out and even getting close to missing a payment.
Even if you pay off your balance in full every month, like Stephanie does, that works to build positive transactions in your credit file. There’s no need to carry debt or pay interest in order to build great credit.
See also: Best Tips to Improve Your Credit Score
What Happens When You Cancel Credit Cards?
Let’s get back to Stephanie’s question about shopping for a new card and potentially closing her existing account.
She mentioned that her current account charges over 20%, but that she generally pays off her balance in full. If you never carry a balance from month to month, your card rate really doesn’t matter because you’re never charged interest.
However, there will probably be a time when Stephanie does want to strategically finance a purchase—like a vacation, furniture, or electronics—or has a large unexpected emergency expense. That’s when a low-rate rate card really comes in handy and cuts your cost.
According to creditcards.com, rewards credit cards, which charge relatively high rates in exchange for goodies like cash back and travel points, charge just over 15% on average right now.
Low-rate cards, with few bells and whistles, come in at 12% on average. So Stephanie can definitely find a card that charges less than 20% to beat her current deal—especially because she has excellent credit.
Before you cancel a credit card here’s what you need to know: it dramatically increases your credit utilization. You might be thinking how can that happen if you don’t have more debt?