With ever-rising prices and credit card interest rates, more consumers are trying to limit their debt by closing credit cards. Besides the need to limit debt, there are many other reasons for closing a credit card account, including high interest rates and fear of identity theft.
Before you close an account, learn how this action can affect your credit score and what will happen to the credit history associated with the closed card. (Do you know how your borrowing activities affect your credit score? Find out in The Importance Of Your Credit Rating.)
Reasons for Closing a Credit Card
There are a lot of reasons for closing a credit card. The following are the most common ones:
- Excessive Spending: When people feel that they are spending too much money and cannot resist the lure of the credit card, they close the account. (The plastic in your wallet doesn't have to hurt your finances. Learn how to manage it responsibly in Take Control Of Your Credit Cards.)
Inactive Cards: When credit cards are no longer being used, their owners typically close the accounts.
Protection Against Identity Theft: With the increase in identity theft in recent years, some people believe that by closing a credit card, they can lessen the chances that their identity will be stolen. (Don't be a victim of this disturbing crime. Get insight into how perpetrators do it in Identity Theft: How To Avoid It.)
- High Interest Rates: Very high credit card interest rates are another reason why people close their accounts. Keep in mind that if you still have an unpaid balance on a credit card with a high interest rate, closing the card will not stop the accumulation of interest on the unpaid balance.
- High Balance: As a form of damage control, some people decide to close a credit card when they have a high balance on it.
Reasons for Not Closing a Credit Card
Whatever reason you have for closing a credit card, it is important to note that not all credit cards should be closed. Here are some reasons why you might reconsider closing a credit card:
- Unpaid Balances: When you close a credit card that has a credit balance, your available credit or credit limit on that card is reduced to zero and it looks like you have maxed out the card. When your credit score is calculated, the amount of debt you have accounts for 30% of your score. Having a maxed-out card, or even a card that only appears to be maxed out, will have a negative impact on your credit score. (We'll tell you how to keep your credit score healthy and your debt under control in Six Major Credit Card Mistakes.)
- Only Credit Source: If you have no other cards or loans, it is not a good idea to close your credit card. A big part of your credit score takes into account the different types of credit you own. If you have no other loans or credit, it is generally a good idea to keep the only one you have open. (To learn more, read How is my credit score calculated?)
- Good History: A good payment history helps increase your credit score, so if you have a good payment history on a card, then it is a good idea to leave that card open. This is especially important if you have a poor history with other cards or forms of credit.
- Long Credit History: This is another important factor in calculating your credit score. A longer credit history can mean a higher score, so if the card in question is one of your older ones, your credit score may be better off if you leave the account open.
Effects on Your Credit Score
The effect a closed credit card account will have on your credit score depends on your credit history and on the current state of your balance/limit ratio.
If you have a good history on a card, closing the card may affect your credit score negatively. The Fair Credit Reporting Act (FACTA) mandates that negative history remains for up to 7 years or 10 years for a bankruptcy. This means that if you close an account with a terrible credit history, in seven years, the negative information will be erased.
While it may seem like a good idea to close a bad account and wait seven years for the information to be removed from your credit report, it is a better idea to work on turning that bad account into a good one by paying off debt and making each monthly payment on time. (Learn five steps to manage debt without cutting up your credit cards in Define Your Personal Debt Redline.)
Your balance/limit ratio, or credit utilization ratio, is simply your credit card balance divided by your credit limit. This ratio is important because creditors and lenders who are considering extending additional credit to you or lending you money like to see that you are making good use of the credit you currently have.
How much of your credit limit you are making use of is the basis for 30% of your credit score. As your balance/limit ratio increases, your credit score decreases because you are seen as being at greater risk of overextending yourself financially. (Read Are You Living Too Close To The Edge? to find out if you're in danger of a financial crisis.)
When assessing your balance/limit ratio, creditors and lenders want to see a low balance in comparison with your limit. For example, if you have three open credit cards with a combined $6,000 credit limit and a combined $2,400 balance, then you have a 40% balance/limit ratio ($2,400/$6,000). By keeping open an inactive credit card with a $1,000 credit limit and a $0 balance, your balance/limit ratio becomes a more appealing 34% ($2400/$7000). FICO (NYSE:FIC) suggests that you keep your balance/limit ratio as low as possible.
What to Do?
Before deciding to close a credit card, take a look at your credit report and assess how closing the account will affect your score. By law you are entitled to one free credit report a year from each of the three credit reporting bureaus. To access your credit report, visit AnnualCreditReport.com. Obtaining your score has a cost, but when you order your score in conjunction with your free annual credit report, the cost is often lower. For more information about your credit score and other credit-related matters, go to myFICO.com.
Remember, whatever your reasons for closing a credit card, the following are important reasons to consider for keeping the card open:
- If you have an inactive credit card or a card with a high balance, cut it up instead of closing it so that the history remains on your credit report but you won't accumulate more charges on it.
- While the temptation to close an account in bad standing is high, closing it actually does more harm than good. It is better to pay off that account than to close it, because closing the account decreases your credit score by increasing your balance/limit ratio.
Be informed about the actions that can affect your credit score and act accordingly, and you'll be a more attractive applicant to new lenders and creditors the next time you need to borrow money.