Saturday, September 6, 2014

How Closing a Credit Card Affects Your Credit Report and Score

By credit expert: John Ulzheimer:

If you follow credit scoring to any extent, you're probably familiar with the concept that closing credit card accounts can potentially lower your credit scores.

The idea that closing a credit card will always have a negative impact upon a person’s credit scores is untrue. There are some scenarios under which closing a credit card is completely benign. Let’s explore the issue in depth.

The Never Ending Myth:

The idea that closing a credit card automatically lowers a consumer’s credit scores due to the fact that the age of the account will no longer be counted is false. FICO® and VantageScore® credit scores still consider the age of closed credit card accounts when determining a consumer’s credit scores. In fact, closed credit card accounts even continue to age as time passes. Keep in mind, however, that closed accounts will eventually be removed from your credit reports 10 years after the closing date and at that time you will lose the value of the age of the card.

Why Closing a card can actually hurt scores:

Credit scoring models are very concerned with a consumer’s revolving utilization (or debt-to-limit) ratio. Revolving utilization is a fancy way to describe the relationship between the balances on all of a consumer’s credit card accounts with the credit limits on his open credit card accounts. Closing a credit card can cause your utilization ratio to go up and, therefore, your scores to go down.

If Joe Smith has 3 credit cards, each with a limit of $2,000 ($6,000 total available credit) and a balance of $1,000 per card ($3,000 total debt) then his aggregate utilization ratio is 50% ($3,000/$6,000 = .50). If he were to close one of the cards his total available credit would be reduced to $4,000 while his total debt remains at $3,000.

Closing that one card just shot Joe Smith’s utilization ratio up from 50% to 75% ($3,000/$4,000 = .75) within the space of a single phone call. This is the one reason your scores would go down because of you closing a credit card account.

Closing Cards Strategically:

Smart consumers know that carrying credit card debt from month to month is a bad idea. Revolving a balance on credit cards is not only bad for a consumer’s credit scores, it is a poor financial decision as well because of expensive interest. The best way to use credit cards is to spend only as much as you can afford to pay off, in full, by the due date. But, if you are resolved in your decision that credit cards are no longer for you, there are a few smart ways you can do this.

Scenario #1

If a consumer has no credit card debt, ever, then he can close a credit card without any impact to his credit scores. Closing a credit card with a high annual fee, for example, might actually be a wise decision. Remember, if the consumer has a $0 balance on his credit card across all of his accounts then his utilization ratio is 0%.

Scenario #2

If a consumer has several credit cards with high limits and wants to close a credit card with a much lower limit, then doing so will probably have little-to-no impact on the consumer’s credit scores, depending on how much debt he’s carrying on other cards. However, unless the card with the low limit has a high annual fee or perhaps a high interest rate, it’s probably a better idea to keep the account open.

Scenario #3

Consider not closing any of your credit cards, ever. Unless your card has an annual fee, it costs you nothing to keep it open. If it has a high interest rate, just don’t use it or use it for minimal purchases, like a tank of gas, so that it can be paid in full easily by the due date. This way you won’t ever have to worry about the potential damage of closing credit cards.  Furthermore, having several different cards can actually come in handy; learn more about the value of carrying multiple credit cards.

Learn more from credit expert John Ulzheimer at:

NEXT POST: What to do when you get a 1099c for an old debt: