Some advisors and money gurus are quick to advise people in debt to cancel all their credit cards, under the misguided belief that it will force the debtor to spend more responsibly and control their existing debt. Not only is this path not effective in creating new habits, it could seriously damage your credit score.
Impact of Balance to Limit Ratio on Credit Scores
Approximately 30% of your FICO score is based on your utilization rate, or the ratio of your balance to your credit limit. In other words, if you have an active credit line of $10,000 and a balance of $9,999, your balance-to-limit ratio is much too high and your credit score is going to drop.
When you cancel a credit card, the available balance is reduced to zero, throwing off your ratio. From a credit rating perspective, if you have a credit card that has reached its upper limits, it is better to stop using it and start paying if off rather than cancel it. As you make payments every month, over time your available credit on that card will increase, giving your FICO score a gradual boost.
While canceling a credit card may be psychologically a good idea for some people, from a credit reporting perspective, there is seldom any positive benefit from doing so.
Getting Some Credit Score Benefit from a Canceled Credit Card
While as a general rule canceling a credit card typically results in a lower credit score, there are exceptions. According to a Bankrate.com interview with a FICO product support manager, one common myth is that when you close a credit card account you lose any positive impact that account could have on your credit score. That essentially it’s wiped off your credit report.
The fact is, after you close an account it remains listed on your credit report, and its credit history is still calculated as part of your FICO score. If you have an account that you held in good standing for 10 years, that account will have a positive impact on your FICO even if you close it. However, a credit card with a long history that’s in good standing is likely to be more beneficial as an active account than a closed one.
When Closing an Account Can Actually Help Your Credit Score
In most cases, closing a credit card account will have either a negative or a neutral effect on your credit score; however, there is one case where closing an account may actually help. The number of accounts you have is one of the factors that go into a FICO score. According to Fair Isaac, your FICO credit score will start to see a negative impact once you have more than seven revolving credit accounts, even if you are paying them all on time every month. If you have that many credit cards, it’s time to pare it down to three or four. Be strategic; your goal is to maintain or improve your balance-to-limit ratio, so closing out the ones with lower credit limits will have the biggest overall impact.
Keep in mind the “right” way to close an account. Cutting the card into tiny pieces is a wonderful symbolic gesture, but when you do so the credit card company doesn’t know it. The account itself is still active. You need to actually call the credit card’s customer service department and tell them to close it.
Getting control over your credit doesn’t mean jettisoning all your cards. Having a few of them, keeping their balance under 30% of the credit limit, and paying the entire balance every month will have a much better impact in the long run.