One of the most powerful tools you can use to manage money and build good credit is a credit card. But the downside is that mismanaging one can be devastating to your financial health.
If you’re considering canceling a credit card because you don’t want the temptation to use it or you want to swap it out for a better card, it’s important to understand how canceling credit cards affects your personal finances.
I received a great question about canceling a card from a member of my Dominate Your Dollars Facebook group named Stephanie C., who says:
“My credit card has an interest rate of over 20% even though my credit is excellent and I’ve never made a late payment in the 14 years I’ve had the account. I rarely carry a balance and use it as an emergency card. If I shop around for a card with a lower rate should I keep this one open until I’m approved for a new card?”
In this post, I’ll give you a good strategy for canceling credit cards that won’t hurt your credit or the chances of reaching your future financial goals.
Free Resource: The Credit Score Survival Kit – download this ebook and video tutorial with proven strategies to build credit fast!
Why It’s Important to Build Good Credit
Before I explain the relationship between credit cards and your credit scores, I want to take a step back to explain why it’s critical to build good credit in the first place. Many people don’t fully understand how wide-reaching credit is.
Having good credit allows you to get the most competitive interest rates and terms on credit accounts such as credit cards, mortgages, car loans, student loans, and personal loans. For instance, paying just 1% less for a mortgage could save you over $100,000 on the cost of a 30-year, fixed-rate loan, depending on the total amount you borrow.
But even if you never borrow money to finance a home, car, or use a credit card, having good credit gives you significant benefits, including:
Lower auto insurance premiums (in the majority of states)
Lower home insurance premiums (in the majority of states)
More rental housing opportunities
Lower security deposits on utilities
More government benefits
Better chances to get a job
The only way to build credit is to have active credit accounts in your name and use them responsibly over time. That shows you’re a low risk to a lender because you can be trusted to repay debt as agreed.
The only way to build credit is to have active credit accounts in your name and use them responsibly over time.
The credit accounts you use and the payment history they report to the 3 nationwide credit bureaus (Equifax, Experian, and TransUnion) lay the foundation for your credit scores. If you don’t have a credit history built up, when you apply for a loan you could be denied because you have a “thin” credit file.
In other words, having no credit is similar to having bad credit because it doesn’t give a creditor information about how you would handle a potential credit account.
The Relationship Between Credit Cards and Your Credit Scores
Your credit utilization, or how much of your available credit you use, is a critical factor in how your credit scores are calculated. It applies to revolving accounts, which don’t have a fixed term, such as credit cards and lines of credit. Credit utilization doesn’t apply to fixed loans—like the kind you get for a car or home—that have an ending date.
Credit utilization is a simple formula that equals your total account balance divided by your total credit limit. For example, if you have a credit card with a balance of $1,000 and a credit limit of $2,000, your utilization ratio is 50% ($1,000 / $2,000 = 0.50).
Keeping a low utilization, such as below 20%, is optimal for good credit. So, by paying down your balance on the card to $400, you could reduce your utilization ratio to 20% ($400 / $2,000 = 0.20) and boost your credit scores.
If you have more than one line of credit or credit card, most credit scoring models calculate your utilization ratio for each account and collectively on all your accounts. So it’s better to spread out your balances on multiple cards and maintain low utilization on each of them, rather than have one card that you charge to the limit.
A low utilization ratio says that you’re using credit responsibly. A high ratio indicates that you may be maxed out and even getting close to missing a payment.
Even if you pay off your balance in full every month, like Stephanie does, that works to build positive transactions in your credit file. There’s no need to carry debt or pay interest in order to build great credit.
See also: Best Tips to Improve Your Credit Score
What Happens When You Cancel Credit Cards?
Let’s get back to Stephanie’s question about shopping for a new card and potentially closing her existing account.
She mentioned that her current account charges over 20%, but that she generally pays off her balance in full. If you never carry a balance from month to month, your card rate really doesn’t matter because you’re never charged interest.
However, there will probably be a time when Stephanie does want to strategically finance a purchase—like a vacation, furniture, or electronics—or has a large unexpected emergency expense. That’s when a low-rate rate card really comes in handy and cuts your cost.
According to creditcards.com, rewards credit cards, which charge relatively high rates in exchange for goodies like cash back and travel points, charge just over 15% on average right now.
Low-rate cards, with few bells and whistles, come in at 12% on average. So Stephanie can definitely find a card that charges less than 20% to beat her current deal—especially because she has excellent credit.
Before you cancel a credit card here’s what you need to know: it dramatically increases your credit utilization. You might be thinking how can that happen if you don’t have more debt?
Before you cancel a credit card here’s what you need to know: it dramatically increases your credit utilization.
Canceling a credit card causes your available credit on the account to plunge to zero. That means your total balances become a higher percentage of your total credit limits, which makes you look riskier, even if you really aren’t. Your utilization ratio spikes and your credit scores can drop right away.
Let’s say you have 2 credit cards and each have a $1,000 available credit limit. If you owe $500 on card A and zero on card B, you have a total limit of $2,000 and a total owed of $500, which is a utilization of 25% ($500 / $2,000 = 0.25).
If you cancel card B because you just paid it off or just don’t like it, you still owe $500 on card A, but your available credit shrinks to $1,000. Canceling the card shoots your utilization ratio up from 25% to 50% ($500 / $1,000 = 0.50), which can instantly lower your credit scores.
For this reason, I strongly recommend that Stephanie keep her existing credit card open. And depending on her situation and goals, it may be best to keep the card even after she gets a new one.
See also: 9 Things That Can't Hurt Your Credit Scores
5 Questions to Ask Before Closing a Credit Card
How you answer the following 5 questions will help you know whether closing a credit card will barely affect your credit scores or cause a lot of damage:
Question #1: What’s the credit limit of my credit card?
As I previously mentioned, if you want optimal credit, never carry a balance that exceeds 20% of your available credit limit. So the lower your credit limit on a card, the less closing it could negatively affect your credit.
Stephanie didn’t mention the available limit on her card, but if it’s more than $1,000, I’d recommend erring on the side of keeping it rather than getting rid of it.
Question #2: How long have I had my credit card?
In addition to making payments on time and keeping a low credit utilization ratio, the length of time you’ve used credit plays a role in how your credit scores are calculated. Having a long, rich credit file boosts your scores and makes you appear less risky to potential creditors.
If you close a card with positive history, it stays on your credit report for 10 years. Accounts with negative, late payment history remain for 7 years.
After these time periods expire, accounts disappear from your record, which reduces your overall average credit history. So think twice about canceling a credit account that you’ve had open for many years, especially if it’s your only card.
Think twice about canceling a credit account that you’ve had open for many years, especially if it’s your only card.
Stephanie mentioned that the card she’s considering closing has been open for 14 years. Because she’s had it for so long, it’s an important part of her credit file.
Question #3: How many credit cards do I have?
If you have credit cards that number in the double digits, you can probably close one or 2 without damaging your credit. However, it’s a good idea to space out the cancellations over time, such as one every 6 months.
But if you have just one or two cards, closing accounts will have a bigger impact by causing your utilization rate to significantly increase. Also, having a mix of credit types—like loans and credit cards—is a factor in how credit scores are calculated.
So don’t cancel your only credit card. I recommend that you always have at least one credit card in good standing.
Question #4: What’s the cost of my credit card?
Some card issuers charge an annual fee—especially when the accounts come with valuable rewards, such as cash back, airline miles, or points for merchandise. Analyze the rewards you’ll get based on how much you plan to use the card.
If you can’t afford the annual fee or won’t use a rewards card, common sense should be the deciding factor, not your credit score.
Question #5: Will I need credit in the near future?
If you’re planning to finance a big purchase, such as a home or vehicle, in the next 3 to 6 months, I don’t recommend closing any credit cards. If your utilization rate increases and your credit scores take a dive during the application process, you may be turned down or offered a too-high interest rate.
What to Do With Unused Credit Cards
If you go through these questions and determine that you should not close a credit card, simply use it to make a small purchase from time to time that you pay off in full, so it stays active.
There isn’t an exact number of active credit cards you need to build or maintain excellent credit. But you may need a low-rate card for times when you must carry a balance and a higher-rate rewards card for charges that you always pay off each month.
No annual fee cards are best, but some of the best rewards cards may charge a fee. It may be worth it, depending on the benefits you’ll get from the card.
The bottom line is that how you open and close cards directly affects your credit scores, so you need a solid strategy to protect your credit.
Related Content: What to Know Before You Cancel a Credit Card
To learn much more about credit, download the Credit Score Survival Kit. It’s a free multimedia resource I created as a gift for you with a video tutorial and 3 smart strategies to build excellent credit scores (that you can real or listen to). Plus, I tell you how to save money by getting your credit score absolutely free as often as you want.
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