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Sunday, August 25, 2013

Does Closing or Cancelling Credit Cards Help Your Credit Score or Hurt Your Credit Score?

Should You Cancel Old Credit Cards?

Choosing a credit card from a wallet
Should you keep all those old credit cards?
Image Source: Public Domain Image by LaTunya Howard

A lot of people have credit cards around that they no longer use.  These may be credit cards that you have paid off long ago, or credit cards that you received but never used.  It seems to make sense to cancel old credit cards that you don't need.  But closing credit accounts can reduce your credit score.  It may sound counter-intuitive, but keeping your old credit card accounts open may be your best move to keep your credit rating high.

How Credit Cards Contribute to your Credit Score

Two major categories of the FICO score that are impacted by credit card accounts:

  • Length of Credit History which makes up 15% of your FICO score
  • Amounts Owed, which makes up 30% of your FICO credit score 

The purpose of the FICO score is to allow lenders to evaluate the risk of loaning you money.  If you have a long history of credit accounts, this will build your FICO score through the Length of Credit History scoring.  Financial institutions like to see a long history of credit utilization- the longer the better.  Some of the metrics used to compute the FICO score involve parameters such as the average age of your credit accounts.  For this reason, consider keeping older credit card accounts open.  Accounts that you have had for a long time contribute more to your credit rating than newer accounts.

The Amounts Owed metric is also impacted if you close a credit account.  Your FICO score will be higher if you have a higher ratio of available credit to amount owed.  If you cancel a credit card, you will lower your available credit suddenly.  Banks like to see available credit since it is less likely that you will max out if you have plenty of credit available.  It also gives reassurance that other lenders have given you substantial credit accounts.

Back of Credit Card
Image Source: by jmlevick

Can Closing Credit Card Accounts Help Me Get a Loan?

If you have multiple credit cards like most people, closing one account shouldn't make a big impact on your credit score- but if you are nearing a large loan such as applying for a mortgage, it may be wise to hold off on canceling any credit cards.  Since 45% of your FICO score could be impacted by closing credit card accounts, you should close accounts gradually rather than closing several during the same month.

In some cases, if you have too much credit available for your income level, it may help secure loans if you do close unneeded credit card accounts.

How Many Credit Cards is Too Many Credit Cards?

The purpose of your credit score is to allow lenders to evaluate the risk of loaning money to you.  Generally having lots of available credit is a good thing.  This will allow you flexibility in managing your debts and you are not likely to max out an account or have trouble paying.  However, based on your income, your available credit can reach a level where your FICO score will decrease based on risk increasing.

What if something happens and you max out every credit card you have available?  Perhaps you spontaneously decide to take a European vacation, or an expensive medical issue occurs.  Would you be able to make minimum payments on all of your cards with your current income?  If not, you are getting to an amount of available credit that would be perceived as a risk by lenders and may begin to reduce your credit score.

How many credit cards is too many?
Image Source: Lotus Head CC-SA-30

For example, if you have 10 credit cards with $10,000 limits and you max all of them out, could you make $200 per month minimum payments on 10 credit cards?  This would add up to $2000 per month.  If this would be outside of your financial means, consider reducing some of your newer credit card accounts to lower your available credit to a more reasonable level.

Should You Keep Old Credit Card Accounts Open?

For most people, your credit score will benefit by keeping old credit card accounts open, even if you have no intention of using them.  Keeping old credit card accounts open builds your credit history and maintains your available credit- both factors that boost your FICO credit score.

Should I Close Unused Credit Cards with Annual Fees?

If you have multiple credit cards and have one or two with an annual fee that you are not using, it probably makes sense to close the credit cards with an annual fee.  Sometimes there are ways to avoid the annual fee on credit cards and keep your credit card.  It is best to close credit card accounts gradually, rather than several within the same month to preserve your credit score.

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