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When I was younger and just getting started with credit cards, I made a habit of closing my old credit card every time I got a new one.
“How responsible,” I thought I was being. With identity theft on the rise, I was sure that leaving open my old credit card would just be an invitation for thieves to swipe in and start making purchases right from underneath my nose.
As one would logically assume, I thought for sure my credit score would benefit from my good deeds. But much to my surprise, that’s not how it works at all.
I remember one day I had applied for a new cell phone and when they ran my credit report, my FICO score was several points lower than the number I was expecting to hear. A few months later (after another cycle of opening and closing credit cards), my score took yet another hit. What’s going on here?
As I later found out, canceling a credit card doesn’t work the way you think it does. Despite your best intentions to be vigilant, closing your accounts will most likely hurt your FICO score.
To better understand why that is, let’s look at two main parts of how your credit score is calculated and see how closing a credit card can affect it.
Credit Utilization Ratio
Out of the five key factors that constitute your credit score, the number of “amounts owed” makes up at least 30 percent of the value. This portion takes into consideration many variables such as the total amount owed and which types of accounts have balances. It also looks at something called your credit utilization ratio.
Simply put, your credit utilization ratio on revolving accounts is the percentage of available credit you're using. For example, if you have one credit card with a $10,000 limit and you spend $2,000 for the month, then you’re utilizing 20 percent of your available credit.
Your FICO score considers your credit utilization ratio because the more credit you use, the closer you are to maxing out your card, and the bigger of a financial risk creditors will perceive you to be. However, there is also a fallacy in this assumption.
Let’s suppose you have two credit cards:
- Credit card A which has a limit of $10,000 and is used often.
- Credit card B which also has a limit of $10,000 and is almost never used.
Let’s also say you regularly spend approximately $3,000 per month on the things you need. That means your total credit utilization ratio would be:
- $3,000 / (2 x $10,000) = 15%
Now, what happens if you decide to cancel credit card B since you never use it. From a mathematical standpoint, look at how this increases your total credit utilization ratio:
- $3,000 / (1 x $10,000) = 30%
The takeaway: Having open cards, even if they are unused, increases the total amount of credit available to you. In turn, that will make your credit utilization ratio look more attractive.
In general, it’s a good idea to always keep your credit utilization ratio to less than 30 percent on any given card. However, if you really want to shoot for the stars with your FICO score, some financial experts recommend keeping it as low as 10 percent.
Also, don’t go too far in the other direction and never use any of your credit cards (bringing your utilization rate down to 0 percent). While zero is as low as you can go, creditors prefer to see at least some level of activity since this can be used to demonstrate that you make payments on time and above the minimum requirement.
Length of Credit Activity
Another place where closing an account could work negatively against you is your “length of credit history”. The age of your credit history constitutes another 15 percent of your overall FICO score.
When we talk about the length of your credit history, this is more than just how long you’ve been using credit cards. It's calculated by taking an average of the history of your active accounts. The keyword here to take notice of is “active”.
For instance, let’s say you’ve got 3 active credit cards that are all in good standing.
- Credit card A is 1 year old
- Credit card B is 2 years old
- Credit card C is 10 years old
When combined, we can see that the average age of your payment history is 4.3 years old.
Now, what happens if you close the credit card that’s 10 years old? Your two remaining active accounts would drop to an average of just 1.5 years old. That’s a pretty significant decrease from 4.3 years, and this will most certainly result in a hit to your FICO score.
The takeaway: If you’d like to game the FICO system, be sure to keep your oldest active card open and in good standing.
When Canceling a Credit Card Makes Sense
Okay, so not every credit card you ever own needs to stay open forever. Not only would that become too cumbersome, but it also wouldn’t serve any practical value. Therefore, we can recommend that you should close your credit card if:
- There’s an annual fee. With charges of $100 or more for most cards, the cost would far outweigh the handful of points you’d lose.
- The card charges an outrageous interest rate. Even if there’s a chance you might make a purchase and then carry the balance, the risk simply wouldn’t be worth it.
- The rewards aren’t that great. With so many credit cards out there that offer incredible rewards for travel or cashback, you’d be far better off cashing in on these opportunities than going without them.
- You just don’t trust yourself. If you already know you’ve got some money management issues that you have to overcome, then credit score hit or not, cut that card up!
Even though it may seem like closing unused credit cards is the responsible move, unfortunately, it's not. Closing accounts can harm both your credit utilization ratio and the average age of your activity history. As long as it makes sense, keep cards that have high credit limits and have been in your pocket the longest. Your FICO score will thank you.
Contributor’s opinions are their own. Always do your own due diligence before investing.
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