Find out the right way to manage credit cards so you can build excellent credit scores and improve your personal finances.
Danielle wants to know:
I have 8 credit cards and carry a small balance on just one of them. Several of the cards have started charging an annual fee that I don’t want to pay. Would canceling those cards damage my credit score?
When it comes to building and maintaining a good credit score, it’s critical to know the right way to manage credit cards. Many people mistakenly believe that getting rid of their cards will automatically improve their credit. The surprising truth is that canceling credit accounts can work against you and damage your credit!
Here are 3 tips to know so you can be strategic about pulling the plug on a credit account:
Tip #1: Maintain High Credit Limits
Credit scores are largely based on the amounts you owe, including your utilization ratio, which is the amount of debt you have compared to your available credit limits. The lower your utilization rate, the better.
Here’s how figure your utilization ratio: Add up all of your debt balances on revolving accounts—like credit cards, retail store cards, and lines of credit—and divide that amount by your total credit limits on those accounts.
By the way, balances you have on business credit cards or employer-issued cards will also affect your credit scores if they’re in your name. This is true even if the company reimburses you for charges you make.
To find out what accounts are being factored into your credit scores, get a free copy of your credit report at annualcreditreport.com. It doesn’t include your credit score—but here’s information about how to get your free credit score.
Let’s say you have 2 credit cards and each has a credit limit 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%. That’s a good ratio. You should always try to keep your credit utilization below 25% to 30%.
You’re penalized for having a high utilization ratio because it’s a red flag to creditors. They figure if you can’t pay down your balances you must be spending too much and are a high credit risk.
How Does Canceling a Credit Card Damage Your Credit?
Consider what would happen if you cancel a credit card because you’re not using it or you finally pay it off. Let’s use my same example and say you close the card with a $0 balance that has a $1,000 credit limit.
Now, your utilization ratio is totally different because your available credit limit has been reduced by $1,000. The revised math is $500 divided by $1,000, or 50%, which is too high. Even though you have the same amount of debt, your utilization ratio makes you appear less credit-worthy because it’s a larger percentage of your available credit limit, and your credit scores will go down.
So, you see that canceling a credit card can hurt your credit because it lowers your total credit limit and raises your utilization ratio. Canceling a credit card with a higher credit limit poses more of a threat than getting rid of one with a smaller limit. L