With rising living costs and ever-higher credit card interest rates, you may decide you can improve your financial well-being and limit your debt by closing credit cards.
Before you do that, though, it’s important to understand the impact that closing a credit card will have on your credit score, including what will happen to any credit history associated with the closed card. Often, there may be smarter ways to achieve your goal of lower costs and less debt.
Key Takeaways
- People close credit cards for many reasons, including excessive spending, avoiding high-interest rates, or protection from identity theft.
- Closing credit card accounts can have an adverse effect on your credit score, mostly because it decreases your credit utilization.
- Keeping cards open, even when they are barely in use, can be beneficial because it keeps your history of payment and age of the oldest credit account positive.
- Solutions outside closing your card might be viable, like asking for a lower interest rate or transferring high-interest balances to lower-interest cards.
Why People Close Credit Cards
Here are some of the most common issues that prompt people to close a credit card:
- Excessive spending: If you feel you are spending too much money, you may figure the best way to regain control and resist the allure of seemingly painless spending with plastic is to close the credit card account.
- Inactive cards: If you’re no longer using a card, you may think it’s best to close the account, especially if you’re paying an annual fee on the card.
- Protection against identity theft: Some people may close a credit card account with the goal of reducing the chance that their identity will be stolen.
- High-interest rates: You may close the account to avoid them.
- Carrying a high balance: As a form of damage control, some people decide to close a credit card when they have a high balance on it.
How a Closed Card Affects Your Credit Score
Closing a credit card account is not always the only—or the best—way to solve these financial issues. That’s because closing an account may affect your credit score—and not in a good way—depending on your credit history and the current state of your balance relative to your credit limit, also known as your credit utilization ratio. Here’s how:
Credit History
If you have a terrible history on a card, the temptation to close an account may be high. The Fair Credit Reporting Act mandates that negative history remain no longer than seven years—or 10 years for a bankruptcy.
You close the account, your thinking goes, and in seven years the negative information will be erased. But that’s true if you keep the account open, too—and work on turning that bad account into a good one by paying off debt and making each monthly payment on time. By closing the account, you’ll increase your balance/limit ratio, causing further damage to your credit score.
Balance/Limit Ratio
Your balance/limit ratio, or your credit utilization ratio, is simply your credit card balance divided by your credit limit. (If your balance is $200 and your credit limit $1,000, your credit utilization ratio is 20%.) This ratio is important because creditors and lenders look at it when considering extending additional credit to you or giving you a loan. They like to see that you are making wise use of the credit you currently have.
In fact, how much of your available credit you are using is the basis for 30% of your credit score. When assessing your balance/limit ratio, creditors want to see a low balance in comparison with your limit. (FICO suggests that you keep your balance/limit ratio as low as possible.)
As your balance/limit ratio increases, your credit score decreases because you are seen as being at greater risk of overextending yourself financially.
Reasons for Keeping a Credit Card Open
So before closing a credit card account, take a good look at your credit report and assess how closing the credit card will affect your credit score. Sometimes there are good reasons to keep an account open. For instance:
- The card shows a good history of payment: A good payment history helps increase your credit score, so if you have maintained a solid record of on-time payments on an account, leave that card open. This is especially important if you have a poor history with other cards or forms of credit.
- You’ve had the card for a while: Length of credit history is another important factor in calculating your credit score – longer credit history can mean a higher score. If the card in question is one of your older ones, removing it will lower the average age of your credit so your credit score may be better off if you leave the account open.
- You only have one credit source: One part of your credit score takes into account the different types of credit you own. If you have no other cards or loans, it is not a good idea to close your only credit card.
Instead of Closing a Card, Consider This
Here is what you might do instead, in five different scenarios.
When You Want to Rein in Spending
Instead of closing the account, you may be better off cutting up the card to resist further spending rather than closing the account. That way, you can avoid a possible hit to your credit rating, which could jeopardize future financial needs.
When You Have an Inactive Card
If the card has no annual fee, you may want to keep it open, especially if you’ve had it for a while, so that its history remains part of your credit report. Keeping it open can also help your credit score in another way—by improving your credit utilization ratio.
If you have three open credit cards with a combined $6,000 credit limit and a combined $2,400 balance, for example, you have a 40% credit utilization 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% ($2,400/$7000).
If you are paying an annual fee on a card you never use, it may make sense to close it. But first, call the credit card company and ask that it be changed to a no-fee card. Often, they will work with you, not wanting to lose a customer. That way, you’ll avoid any impact on your credit score.
When You Need to Manage High Unpaid Balances
If you close a credit card that has a credit balance, your available credit or credit limit on that card is reduced to zero, making it appear that you have maxed out the card.
A maxed-out card—even a card that only appears to be maxed out—will have a negative impact on your credit score because it will increase your credit utilization ratio. If you’re worried about accumulating more charges on an already high balance, once again it may be better to cut up the card than close it.
When Your Card Has a High Interest Rate
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.
A better solution may be to call your credit card company to ask for a lower interest rate, especially if you’ve had the card for a while and your credit rating has improved since you got it.
You also can work toward paying off your entire balance each month. Think of it this way: If you never carry a balance from month to month, it doesn’t matter what your interest rate is. Your annual interest charges will still be zero.
When You Are Dealing With Identity Theft
There are more effective ways to protect your identity than closing down a credit card account.
The Bottom Line
Remember, whatever your reasons for closing a credit card, there are often smarter alternatives that will leave your credit rating intact and keep you on a path toward sound financial health.
Be informed about the actions that can affect your credit score and act accordingly. Visit AnnualCreditReport.com and get the free credit report that you’re entitled to by law once a year from each of the three credit reporting bureaus. Obtaining your credit score is not usually free, although several banks now give cardholders free access to their FICO scores. Also, when you order your score in conjunction with your free annual credit report, the cost is often lower.
By being an informed consumer, you improve your financial health and become a more attractive applicant to new lenders and creditors the next time you need to borrow money.
Read the original article on Investopedia.