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You Pay Off a Credit Card—Now What?

Did you know that paying off a credit card balance and closing a bank account can accomplish different things for your credit?  Money Girl answers a reader question

By
Laura Adams, MBA,

You Pay Off a Credit Card—Now What?

 

A Money Girl Facebook fan named Victoria A. asks:

"We have accounts at 3 different banks and are closing one of them. But we also have a credit card from that bank that’s paid off. I read that closing a credit card can be bad for your credit. When the card expires, will that still hurt my credit score?"

ANSWER:

Don’t assume that closing a bank checking or savings account means that your credit card from that institution will also be closed.

Revolving credit accounts—such as credit cards and lines of credit—don’t “expire” if you pay off the balance; they stay open until you specifically request cancelation. However, some card companies may close your account for inactivity if you don’t use it for a long period of time.

In some cases, you may have to keep a checking account open with an institution to get special terms (like a lower interest rate) on their credit cards or lines of credit. So Victoria should be clear about what she’s trying to accomplish—getting rid of a bank account or a credit card.

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Victoria is right; closing a credit card can damage your credit scores. That’s because most credit scoring models factor in your credit utilization ratio, which is your total debt on revolving accounts compared to your available credit limits on those accounts, expressed as a percentage.

Credit utilization is typically the second most important factor in how credit scores are calculated, behind making payments on time. A ratio under 30% is recommended for maintaining optimal credit.

Closing a revolving account can damage your credit because you instantly reduce your available credit and raise your utilization ratio. Here’s what happens:

Let’s say you have 3 credit cards with credit limits of $1,000 each and you owe $750 on one of them and $0 on the other 2. Your credit utilization is:

 $750 debt / $3,000 available credit = 0.25 = 25%

If you close one of the cards with a $0 balance, you give up $1,000 of available credit and your new ratio is:

 $750 debt / $2,000 available credit = 0.38 = 38%

Increasing your credit utilization from 25% to 38% will cause your credit scores to decrease. Even though you aren’t actually taking on more debt, using up a higher percentage of your available credit is a red flag to potential creditors and merchants.

I don’t recommend keeping more credit cards than you really need—but be strategic about closing them. If you might need credit in the near future, wait until that transaction is complete before closing any revolving credit accounts.

Also, remember that credit scores affect several areas of your financial life besides qualifying for a new loan including insurance quotes, renting an apartment, and getting a job.

Looking for smart strategies to raise your credit score fast? Download the Credit Score Survival Kit. This free multimedia resource will help you fast-track your credit success and show you how to monitor your credit report and credit scores for free.

Other Articles and Resources You Might Like:
What to Know Before You Cancel a Credit Card
Does Canceling a Credit Card Hurt Your Credit?
How to Get Credit With No or Bad Credit
Credit Score FAQ (VIDEO)
The Best High-Yield Checking Accounts for 2012

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Credit cards photo from Shutterstock

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