Original article by Bill Hardekopf, Edited by Robert Weinberg
Credit cards are like relationships. It's sometimes hard to break up and the split may hurt you more than the other party involved. While it may give you all sorts of warm and fuzzy feelings to cut up that credit card, losing the available credit could hurt your credit score and raise the costs of future financing and loans you take out.
Closing a credit card account that you have paid off or don't use seems like a logical thing to do. However, the "credit utilization ratio" is one of the major factors in calculating your credit score, accounting for approximately 30 percent of your score (and the highest percentage of any factor). Closing an account can have a dramatic negative effect on that ratio.
When it comes to your credit cards, the credit utilization is the ratio of all your credit card balances to the credit limits available on your cards. Having a low ratio (not having much debt but a lot of available credit) is beneficial to your credit score. A high ratio may indicate that you may be a risk for default. A healthy credit utilization ratio is anything below 30 percent (I try to have most clients stay below 20% for maximum score enhancement).
Closing an old or unused card erases some of your available credit and increases your credit utilization ratio. For example, say you have two credit cards. You have one with a $3,000 balance and one with no balance, and each card has a $5,000 credit limit. Your credit utilization ratio is currently 30 percent ($3,000 divided by $10,000), a very attractive ratio for lenders to see. But if you close the account with no balance, you decrease your available credit by $5,000, so your credit utilization ratio increases to 60% ($3,000 divided by $5,000).
Another major factor in calculating your credit score is the length of time you've had credit. If you have to close a credit card account and you are choosing between two equal cards, close the one with the shorter history. It is usually better to keep your credit card accounts open for a long period of time.
Rather than closing an inactive credit card account, it may be beneficial to keep that account open and just make a small transaction on it every month or two. Buy lunch on that card and pay that balance completely at the end of the month. That will keep your account active and enhance your credit score by prolonging your account history and keeping your credit utilization ratio low.
Here are some considerations on whether to cancel a credit card account:
* Look at your total available credit. Add up how much available credit you have and how much credit you are using. Your goal should be to keep your credit utilization ratio below 30%. If you have few credit cards, or a high credit utilization ratio, keep the account open. If you have several credit card accounts with large credit lines and you pay them off each month, you should see a minimal effect from closing a credit card.
* What is your credit score? If your credit score is excellent, losing a few points won't be a big deal. If you are building or repairing your credit score, leave the account open.
* Does unused credit tempt you to overspend? If these temptations have historically gotten in the way of sound financial judgment, it is better for you to close an account even if it does slightly lower your credit score. Running up needless debt is one of the worst financial mistakes you can make.
* Will you be applying for a loan in the near future? If you have a good credit score and no plans to apply for a loan, close the account. However, if you are going to buy a house or a car in the near future, keep your credit accounts open until you have been approved for the loan.
If you do choose to cancel your account, follow these steps:
* Pay off the total credit card balance.
* Wait for the next bill or call customer service to make sure the balance is zero.
* Call customer service and cancel the card. They will ask a few questions and may even offer some incentives to change your mind.
* Send a written confirmation and keep a copy for your records.
* Check your credit report to make sure the account is closed. This will take a few weeks. Go to www.annualcreditreport.com and check your report for free. Every year, you get one free credit report from each of the three credit bureaus