girl-phone-cardThose little pieces of plastic may look harmless, but anyone who’s fallen into credit card debt can tell you that carrying around that American Express or MasterCard can actually be very dangerous.

After paying off your debt, it can be tempting to call up your credit card companies and cancel all of your cards. While this will prevent you from ever spending money you don’t have again, it’s not necessarily a wise idea.

Here’s the deal: closing a credit card will never help your credit score, but it can hurt it. That being said, it doesn’t always hurt your credit.

So, should you cancel that credit card or not?

How Cancelling a Credit Card Can Affect Your Credit

In order to understand how closing an account affects your credit, let’s take a look at how it could impact each of the five components that make up your credit score.

Payment history: 35%
Whether or not you’ve been paying your bills on time is the most significant factor in determining your credit score. If you’ve had trouble paying a credit card bill on time, you might be tempted to close it and hope that your negative payment history with that account will disappear.

Unfortunately, it won’t. According to FICO’s principal scientist Frederic Huynh, the payment history on a closed account will still be used to determine your FICO score.

Verdict: Cancelling a credit card does not affect your payment history.

Amounts owed: 30%
This is also known as your credit utilization rate, or the ratio of your available credit to debt, and it’s a very important but often overlooked component to your credit score. You want to try and keep your credit utilization rate below 20%.

For example, say you have three credit cards with the following limits and balances:
Credit card #1: $500 limit, $300 balance
Credit card #2: $1,000 limit, $500 balance
Credit card #3: $2,500 limit, $0 balance

Your total available credit is $4,000, while your total credit card debt is $800. To figure out your credit utilization rate, you divide $800 by $4,000, which is 20%. Perfect.

Using the example above, say you decide to close credit card #3 because you never use it. That would bring your available credit down to $1,500, and with the balances on your other two cards, your credit utilization rate would shoot up to 53% and your credit score would likely decrease.

Verdict: This is often where your credit score is most impacted by the cancellation of a credit card. It is wiser to cut up the card and stop using it but leave the account open. If you must close the account, then you should try to pay off your remaining balances on other cards first.

If you pay off all your credit card debt, your credit utilization rate will be 0 no matter what.

Another option would be to apply for a card to replace the card you’re closing, or to ask for a credit limit increase on your other cards.

Length of credit history: 15%
Another factor is the length of your credit history, which is determined by how long you’ve been using credit. However, credit card accounts will remain on your credit report for 10 years, even after they’ve been closed.

Let’s say you have three credit cards – you got the first one eight years ago, the second one seven years ago, and the third one four years ago. Your credit history is eight years. If you want to close the first one, your credit history will remain the same until ten years later, when the first card falls off your credit report. Your credit history will decrease by one year, which isn’t a big deal.

However, let’s say you got your first credit card twenty years ago, and then didn’t get another one until five years ago. If you close the first credit card, once it falls off your credit report, your credit history will be shortened by fifteen years. This could affect your credit score.

Verdict: The length of your credit history is only impacted by cancelling a credit card if the card you want to cancel is your oldest card by a long period of time. If it is, you should try to keep it and cancel a different card instead.

New credit: 10%
This factor looks at how much new credit you’ve opened recently. When you apply for a new credit account, the lender checks your credit score, which is called an inquiry. An inquiry here and there isn’t a big deal, but too many inquiries into your credit report and multiple new accounts can lower your credit score.

Verdict: Cancelling a credit card does not affect your new credit.

Types of credit used: 10%
Your credit score is also determined by the various types of credit you use: the more the better. For example, having a home loan, student loans, and credit cards is better than just having student loans, assuming you’re paying them all off responsibly.

Verdict: This factor is only impacted by closing a credit card account if it’s the only credit card you have. If you don’t have any other credit cards, you should consider keeping it open to maintain a mix of different types of credit.
The Do’s and Don’t’s of Cancelling Credit Cards

Do:

  • Try to keep your oldest account open.
  • Keep accounts with favorable terms and interest rates.
  • Close accounts that have high annual fees and aren’t in use.
  • Pay off your balances on all other credit cards before cancelling one.
  • Try bargaining with your credit card company. Sometimes they will remove annual fees or lower your APR.

Don’t:

  • Close accounts if you’re fairly new to credit.
  • Close accounts right before applying to finance a major purchase.
  • Close multiple accounts at once. Space it out.
  • Think that cutting up a card means that it has been cancelled. You have to actually call the credit card company.
  • Close your only credit card.

When to Close a Bad Account

Deciding whether or not to close a bad account is a little trickier.

Closing any credit account, good or bad, can affect your credit score in the ways I detailed above. That being said, if you have an account in bad standing or an account that shows late payments, it will continue to negatively affect your credit score indefinitely. If you close it, the account will come off your credit report in seven years entirely.

However, accounts that were paid off and then closed will reflect positively on your credit score. Therefore, the ideal thing to do in this situation would be to turn the account around. If you work hard making monthly payments and are able to move the account from bad standing to good standing, that will help your credit more than trying to make the bad account disappear.

If you know that you won’t be able to turn the account around due to tight finances, then it is probably in your best interest to go ahead and close it so that any bad marks will fall off your credit report sooner.

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