Credit Repair

How Closing a Credit Card Affects Your Credit Score

Having too many credit cards may lead to unnecessary annual fees or a temptation to overspend. In some cases, having a lot of credit cards is an identity theft risk.

But should you cancel your unused credit cards? That depends — closing old accounts can hurt your credit score. Here are things you need to know before you cancel a credit card.

Why closing a credit card hurts your credit score

Understanding your credit utilization ratio

Why the age of your credit card accounts matter

When will closing a credit card cause minimal damage?

Should you keep old credit cards open?

Why closing a credit card hurts your credit score

Your credit score can reflect the likelihood that you’ll repay a loan. Banks and credit card issuers prefer to lend money to people with stable, low-risk profiles. Unfortunately, lenders see credit card cancellations as a red flag.

When you close a credit card, you have less available credit. It starts to look like you’re running into your capacity to pay back loans. As a result, your credit score takes a hit. But the size of a credit hit and the length of time it takes for your score to recover vary.

According to credit scoring company VantageScore, closing an old credit account causes an average credit score to drop 15 to 30 points. It takes about three months for your credit score to recover from the hit.

However, the worst hit happens when you already have a low credit score. A study by the Federal Reserve Bank of Philadelphia looked at a group of people who took out secured credit cards. About 7% of these borrowers closed their secured credit cards without a balance, within two years of opening their account. This group saw their median credit score drop from 568 to 522. Borrowers who kept their accounts open saw their median scores rise from 589 to 613 during the same time frame.

One reason why your credit score drops after closing a credit card is because doing so affects your credit utilization ratio.

Understanding your credit utilization ratio

Your credit utilization ratio is the amount you owe on credit cards divided by your credit limit. This number makes up 30% of your overall credit score in the FICO credit score model.

FICO reports that borrowers with the best credit scores have a 6% credit utilization ratio on average. Most experts recommend that you keep your credit utilization ratio below 30%.

When you cancel a credit card, you reduce your available credit. This drives up your credit utilization ratio — and a higher credit utilization ratio makes you look like a riskier borrower.

Canceling a credit card with a balance has a “doubly” negative effect. When you close a card with a balance, the balance on the credit card will continue to count toward used up credit. However, the credit limit on the card will fall to zero. The result is a dramatic increase in your credit utilization ratio.

Why the age of your credit card accounts matter

FICO and other credit scoring models consider the length of your credit history when calculating your credit score. In fact, the average age of your accounts counts toward 15% of your FICO Score. When you close an older credit card account, you may decrease the average age of your accounts. Doing so could hurt your credit score.

But why do lenders care about the age of your credit accounts? Older accounts give lenders a clearer picture of how you manage credit. The age of an account reflects how long you’ve been managing credit, which could be reflective of how well you can handle credit.

When will closing a credit card cause minimal damage?

Of course, not everyone will see their credit score suffer from closing a credit card or two. People who have tons of available credit and little debt may find that their credit score only drops a few points after closing a credit card account.

Consider a person who has $70,000 credit limit spread across five credit cards. If that person has an average balance of $3,000, she has a credit utilization ratio of 4.3%. Closing a credit card with a $10,000 limit will only increase her utilization ratio to 5%. Such a small increase in credit utilization will have a minimal effect on her credit score.

In rare cases, closing a credit account could improve your credit score. For example, if you have a new credit card, closing it may increase the average age of your credit accounts. The increased average age of your accounts could offset the higher credit utilization ratio.

Should you keep old credit cards open?

Keeping old credit cards open will help you keep your credit score high, but holding onto old cards isn’t always the right choice: for example, you may decide to shut down credit cards that carry a high annual fee. However, to avoid the credit hit, you could ask the credit card company to convert your card to a no-fee card.

Too many credit cards may also pose a security risk. If you have a lot of credit accounts that you never check, an identity thief could steal the account without your knowledge. Even though you’re not liable for unauthorized credit use, you’ll still have to report and resolve issues related to identity theft.

Another reason to cancel a credit card is to stop taking on more high interest debt. By cancelling your credit card, you force yourself to stop overspending. However, you may want to speak to a certified credit counselor before you cancel your cards. The credit counselor can help you create a plan to pay off and avoid high interest debts.

Before closing your credit card account

Before closing down an old credit card, take these five steps:

1. Request a fee waiver or a card conversion

Some credit card companies will waive an annual fee, or convert a card with a fee to a no-fee account. Before you cancel your credit card, call the lender to see if it will work with you.

2. Redeem or transfer rewards

When you close down a credit card, you may lose accumulated rewards. Before you cancel your card, redeem those rewards. In some cases, you may be able to transfer your points or miles to an airline or hotel loyalty program. Check the fine print on the credit card rewards program to learn your options.

3. Apply for loans, mortgages or new credit cards

Cancelling an old card could hurt your credit score and limit your chances of finding a great rate on a loan.

4. Transfer or pay off the balance

You can shut down a credit card with a balance, but that’s not ideal. Try to pay off the card’s balance before shutting it down. If that’s not possible, transfer the balance from a high interest card to a 0% balance transfer credit card.

5. Consider credit counseling

A non-profit credit counselor or an accredited credit repair company can help you design a plan to eliminate credit card debt and live within your budget. Credit counseling could be more helpful than canceling credit cards without a plan.

Carefully consider whether or not your credit score can take a hit. Your credit score is an important factor when you apply for a loan or other financial product. So if you need to close a credit account, be sure to time it so that it doesn’t hurt your chances of a loan or other financial product.

 

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