Debt isn’t always straightforward nor is it always a bad thing. You can have a $500,000 mortgage, a couple of car loans, and $50,000 in credit card debt and still live comfortably with a strong credit score. At the same time, however, you could have a personal loan of just $2,000 that cripples you financially and destroys your credit score.
It’s all relative and at times it can be confusing. One of the most confusing aspects is that, sometimes, the things you do to improve your score and financial situation actually do more harm than good. As an example, if you clear a maxed-out credit card your situation will improve, but if you then cancel that account, your credit score will suffer and return to the way it was before.
So, what’s happening here, why does cancelling a credit card have such an adverse effect on your credit score and how can you get rid of those accounts without suffering any consequences?
How Cancelling a Credit Card Affects Your Credit Score
Before we look at the reasons that canceling a card can adversely impact your credit score, we need to understand how credit scores work and why they exist. Contrary to what you might think, they are not simple scoring systems that reward you every time you pay your debts and punish you every time you make a mistake. They are much more complicated than that.
Why Credit Scores Exist
Imagine that a friend of a friend asks to borrow $1,000 and insists they will pay it back. You don’t know them that well, but you’re generous and stand to make a few dollars from the arrangement, so you’re receptive to the idea.
The problem is, $1,000 is a lot of money and you have no recourse for action if they decide to stop making their promised payment. To get around this, you ask a few of your mutual friends, all of whom have some financial experience with the borrower, either because they charge them rent or have loaned to them before.
Taking the information provided to you by these friends, you create a risk-reward plan and base your interest on that. If they give you an expensive watch as a deposit, you charge them interest of just $10 as you know that watch is yours if they fail to pay. If not, and if they have a shaky credit history, you charge them interest of $100.
This is essentially how lenders work and the system we have now is an extrapolation of that. In the old days, lenders would share information about borrowers, including blacklists. They would also post about unpaid debts in the local press and even announce it to local businesses and communities, warning other prospective lenders. Credit scoring systems do all of this automatically, but they exist for much the same reason.
Lenders don’t have to report to credit bureaus, but they often do, and when they do, that information will be used to build a credit score that tells others about your creditworthiness. In other words, your credit score is not there for your benefit, it’s there for the benefit of lenders who peruse your credit history, check your credit accounts, and then determine if you’re a good fit.
Credit Report vs Credit Score
Your credit report and credit score are two separate entities. The former is provided by one of the three major credit bureaus while the latter is based on an algorithm that takes all credit report data into account.
It can be created by FICO or VantageScore, the latter of which was developed as a joint effort by the three credit bureaus, but in most cases, when you see a reference to a credit score it’s referring to your FICO score.
How Credit Scores are Calculated
FICO has yet to provide detailed information on how the credit score algorithm works and how much each action can affect it. However, there are a few things we do know about this scoring system.
Firstly, the effects that a positive or negative action has on your score will depend on how high or low your score is. A derogatory mark will impact an Exceptional score more than a Poor one. The former will still be stronger than the latter after this mark has been taken into account but it will lose more points.
We also know how credit scores are weighted:
- Payment History = 35% – A record of all your previous payments. The only way to improve this aspect of your score is to keep meeting those monthly payments and bide your time. Any late payments will have a seriously detrimental effect on this part of your score.
- Credit Utilization Ratio = 30% – Debt is relative. What is insignificant to one person is massive to another. Simply calculating total debt, therefore, wouldn’t be an accurate metric. Instead, the FICO credit scoring model compares debt to available credit and looks at how much you have used.
- Age/History = 15% – The older your accounts are, the more trustworthy you seem as a borrower. This means you can improve your credit simply by waiting.
- Credit Mix = 10% – Lenders like to see multiple types of debt, from credit card debt to a loan, mortgage, and more.
- New Credit Accounts = 10% – All new accounts will impact this aspect of your score, although FICO has yet to provide information on when a “new” account stops being new.
Why Can Canceling a Credit Card Affect Your Credit Score?
After reading all of the above, you may have already worked out the reasons why canceling a credit card can reduce your credit score. Simply put, once you close an account, you’ll remove the entirety of the credit limit and this, in most cases, will negatively impact your credit utilization ratio.
As an example, let’s imagine that you have 2 credit cards, each with a limit and debt of $10,000. At this point, your credit utilization ratio is 100% ($20,000 is 100% of $20,000), which is a great deal higher than the ideal limit of 30%. If you receive a financial windfall and use it to clear one of those cards, you will reduce your debt by $10,000 while maintaining a $20,000 credit limit.
However, if you then close that credit account, your credit limit will drop to $10,000 as well, thus returning your credit utilization ratio to 100%.
Your credit utilization ratio isn’t the only thing that will suffer. If that credit card is one of the oldest accounts that you have, closing it will greatly reduce the average age of your accounts. If it’s the only credit card you have then your credit utilization score might not suffer, but your credit mix might.
Reasons Credit Card Accounts are Cancelled
Credit card accounts are often closed to remove temptation after a major debt payoff. They can also be closed as part of a debt management plan, whereby the providers often insist that the debtor cancels all but one credit card.
Some debtors cancel their credit cards with the belief that doing so will remove the account from their credit report, taking all the negative marks with it. However, this is simply not the case—derogatory marks resulting from late payments and other issues can remain for up to 7 years and some can remain longer.
Pros and Cons of Keeping Credit Card Accounts Open
The biggest issue with closing a credit card account, as discussed already, is that it may reduce your credit score in the short-term. However, if you keep meeting your debt obligations, don’t acquire any new debt and don’t initiate too many hard inquires then your score will gradually improve and after a few months, the impact of that closure will reduce. This is especially true if you have a strong credit history and other credit cards with little to no debt.
Closing the account will also reduce your chances of falling prey to identity theft, which is becoming increasingly common, and it will ensure that you don’t pay any additional annual fees or other charges. It also removes temptation, although in doing so it removes a potential emergency payment method that could help you out in a time of need.
If you keep it open you won’t suffer any major credit score reductions in the short terms, you can use it for emergencies, and if you ever change your mind and decide to return to using the card full-time, you won’t have to go through the application process, which can also hurt your credit score.
It’s a mixed bag, but the good news is that it won’t destroy your finances if you make the “wrong” decision. There isn’t even a wrong decision to make.
What Should You Do if You Have Too Many Credit Cards?
If you’ve found yourself inadvertently collecting credit cards and debts, and you have no intention of setting a new record, then it could be time to get rid of some of them. For cards that have balances, consider a balance transfer card, which will move multiple balances onto a single card and make them more manageable.
A balance transfer is a form of debt consolidation tailored towards credit card debt. It allows you to transfer up to 5 credit card balances onto a single card, but it’s offered as an introductory offer, so you need to seek a new credit card company for this to work.
For cards without balances, look at the rewards and benefits, get rid of the ones that charge a high fee and interest rate, and keep the ones that offer the best perks and terms. The fact that these cards have no balance means your credit utilization score will be low regardless. You may still suffer a slight credit score reduction when you close the unused cards, but if you have a good payment history it will be minimal.
How to Close a Credit Card Without Hurting your Score
You can close a credit card to prevent any more transactions taking place, but it will remain active until the balance has been repaid in full. Make sure you pay this balance before going any further and keep the following in mind as well:
- Collect Rewards: If you have a rewards credit card, be sure to collect all the rewards due to you before you close the account. These rewards may be infinitesimal, and the lender may encourage you to wait longer and spend more to accumulate additional points, but you’ll likely pay more than you’ll save if you do.
- Be Firm: Contact your provider to make your request and close the account. They will persist and will likely make you a host of offers for new cards and rewards, but if you persist and remain firm, they’ll give up and will eventually cancel. It’s important not to be drawn into these offers as they hurt your credit in the short-term and your finances in the long-term.
- Write a Letter/Email: To be on the safe side, write the bank a letter confirming your request to close and take a picture of the letter. You can also send them an email and copy yourself in. That way, if there are any mistakes and those mistakes affect your credit score, you have proof of your request.
- Check: The last step is to check your credit report and confirm that the account has actually been closed. You can get a free copy of your credit report to do this and should check at least a month after your request.
Summary: Credit Cards and Your Credit Score
There are a lot of myths and misunderstandings with regards to credit cards and the way they impact your credit score. We could fill an entire website with these and there’s a good chance you believe a few of them yourself.
So, let’s finish by adding some truth and clarity to this issue:
You Don’t Need a Balance to Benefit
The idea that you need a balance to benefit from credit score improvements is not only wrong, but it’s also dangerous. As far as your credit report is concerned, you accumulate debt every time you use the card. It doesn’t differentiate between a rolling balance and one that will be paid off until it actually is paid off. In both cases, your payment history will benefit, but it’s always best to clear the balance in full when you can.
Even an unused credit card will help your credit score, because the longer that account is tied to your name, the older it will become and the higher that aspect of your score will climb.
A New Account Won’t be Catastrophic for Your Credit Score
If record holders in the US and China can open over 1,400 credit card accounts without destroying their credit report, it should go without saying that a single account doesn’t make that much of a difference.
Your score may suffer slightly when you open a new account, but providing you meet your repayments every month then that drop will be minimal and your score will soon improve.
Balance Transfer Cards Don’t Always Charge More
It’s true that many balance transfer credit cards offer higher variable APRs once their interest-free periods end. However, this is not true for all of them and there are many cards that offer great balance transfer rates in addition to a small annual fee (or no fee at all) and a bunch of rewards and perks.
A Debt Consolidation Loan is Not Always Cheaper
A debt consolidation loan can reduce your monthly payment and may be offered at a lower interest rate. However, lenders are not in the business of making your life easier. They’re in it for the money and the only reason debt consolidation loans exist is that they greatly extend the term of the loan, thus increasing the total amount you will repay.
A debt consolidation loan can help with credit card debt, but it’s a solution that focuses heavily on the short-term and hopes you will ignore the long-term consequences.
You Don’t Need an Unsecured Credit Card to Build Credit
We have extolled the virtues of secured cards many times on this site and it’s worth mentioning them again here. A secured credit card requires a small deposit (often around $200) and offers a credit limit based on the deposit. It’s designed to help you build credit when you have none and it does a pretty good job.
You don’t need an unsecured card with a massive limit to build a strong credit score. Just get a secured card and keep clearing that balance every month.