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There has always been a lot of chatter about applying for a new credit card, such as how long to wait before applying for a second card or asking how many credit cards are too many. However, there is also a lot of interest for those that want to close a credit card account as well. Including how an account closing will affect a personal credit score and the odds of approval when applying for future forms of credit. Whether you want to slim your wallet or remove a spending temptation before a credit card account is closed, here are some things to consider.
Your Credit Score is Negatively Impacted
It’s a common fact that opening a new credit card will temporarily reduce a few points on your credit score. What many people might not realize is that closing a credit card has the same effect. Here’s why.
Less Available Credit
Your credit score is composed of several factors including payment history, age of credit history, mixture of credit types, and the credit utilization ratio. Canceling a credit card impacts these four criteria as it gives prospective lenders, employers, or landlords less information on how you are currently managing your money and available credit.
Having less credit available to use might not be a bad thing if you are more prone to maxing out a credit card and going into debt. Most people could not afford to use all their available credit, but, lenders compare how much credit you actually use compared to how much can be used. This is called the credit utilization ratio.
One key to maximizing your credit score is to use no more than 20% of your available credit. Assuming you have $10,000 in available credit, only spending $2,000 at most will keep your ratio below the 20% target. Hypothetically, if you own two credit cards each with a $5,000 credit limit and cancel one of them, your available credit drops to $5,000 and your utilization ratio jumps to 40%. It’s not the end of the world, but, you score will not be as high as it could be. The reduction will differ for each person, depending on their creditworthiness, so using a free credit score simulator like Credit Karma might be useful.
Lack of Credit History
A higher credit utilization ratio is a near-term effect, but, after 10 years, the canceled credit card is dropped from your credit report and is ancient history. Before it is removed from the credit report, anybody pulling your report can look at the account history to look at the payment history and the credit limit to help determine if you used the card responsibly. After ten years, that is no longer possible. If you have never had many forms of credit, this can negatively affect you more than somebody that still has 3 active credit accounts after they shut down a credit card.
Less Mixed Credit
The credit bureaus and lenders like to see a good mix of credit, and, it also accounts for 10% of your FICO credit score. This helps show them that you can manage more than one form of credit, in addition to an auto loan, home loan, or student loans. As credit cards are a variable account that can remain open indefinitely they help show you can manage your finances responsibly each month, whereas fixed loans quit recording payment history once you pay it off in full.
Do Not Close an Account When Applying for a New Loan
If you are planning to apply in the next few months currently or in the process of applying for a new loan, you should wait to close an account after that loan decision has been finalized to ensure you have the highest score possible. Closing a credit card will immediately reduce your score a few points and it can take a few months for the score to return to its previous level.
Also, canceling your account during a complex loan like a home mortgage that can take several weeks can give the underwriters a fit and delay your application if financial information needs to be recalculated. If the delays take too long, you can jeopardize the entire home purchase and start over from scratch.
Banks Can Close Your Card Due to Inactivity
It is possible for banks to close your credit cards and store charge cards after a predetermined period of inactivity, normally two to three years of inactivity. They might reduce your credit limit first, which can also affect your credit score, before closing the account outright.
If you do not plan to use the account, keep it open as long as possible and letting the bank decide when to close the account will not hurt anything and can help lengthen how long the credit account will remain on your credit history report before the 10-year drop-off. Plus, it saves you the time of making a phone call to customer service or speaking a “retention specialist” that will try to offer incentives to keep to keep the account and spend money not included in your household budget.
Of course, it’s also recommended to enroll in a credit monitoring service or to check the account monthly to make sure the account information has not been stolen and used for fraudulent purchases. If you do not want to take the additional risk of identity theft from an idle account, canceling it can give you peace of mind. And the additional benefit of removing the temptation to go on a shopping spree with easy credit.
Consider Downgrading Instead of Canceling
Sometimes it is better to downgrade than cancel. If you have a credit card with an annual fee that you no longer want to use, but the credit card company has a cheaper or free alternative, it’s possible to ask their customer service to convert your account to the cheaper card. This option can prevent a credit score penalty and might also allow you to keep your credit history intact. Of course, one downside is that you might not qualify for any sign-up bonus that new applicants would receive.
Change Your Automatic Payments
Just like when your credit card information is compromised through fraud, credit card companies most likely will not alert companies that automatically charge your credit card each month of automatic bill payments. You will need to manually change the payment method for each merchant to avoid getting hit with late fees. It might be a good idea to do this a month before you plan to cancel an account just to make sure no charges are still applied to the card that will be canceled in the very near future.
Author: Jeff Gitlen
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