Cutting back on credit cards can make sense
New credit card offers can be tempting, especially when they tout a lower interest rate or more attractive rewards than what’s in your wallet.
But before you sign up for yet another card, consider whether you’d be better off financially closing out any of the cards you already have.
Establishing credit can be tough, as many recent college grads are bound to discover. That makes many consumers reluctant to give up any financial flexibility. And it’s true that closing out a credit card account that you’ve had for years can temporarily hurt your credit score.
As a result, many consumers often hang on to older accounts, even if the terms on those cards carry a higher interest on balances or an annual fee. But such worries can be overblown.
“Don’t let concerns about a credit score cause you to make a bad financial decision,” said Rod Griffin, director of public education for Experian, one of the big three credit bureaus.
Many factors go into determining your credit-worthiness, whether it’s the FICO score or a similar benchmark.
Credit scoring systems essentially weigh how borrowers handle credit, from auto and student loans to credit cards and mortgage payments.
When it comes to credit cards, borrowers with the highest credit scores will generally have made timely payments for several years. They’ll also have kept any balances well below the limits of their available credit. That last piece of the credit scoring puzzle is also known as credit utilization, and it’s one of the factors that can hurt you when you close out a credit card account.
Credit utilization is the percentage of a cardholder’s available credit that is being used at a given time. The more credit the borrower taps, the lower their available credit, which can bring down the credit score.
Let’s say a borrower has four cards, each with a $5,000 limit and two of the cards are nearly maxed out, while the other two have no balances. That cardholder has a credit utilization rate of about 50 percent, reflecting available credit of $10,000. But drop one of the cards without a balance and the borrower’s available credit falls to $5,000 and the credit utilization surges to 75 percent.
“If everything else in a person’s credit report remains the same, then increasing their credit utilization may result in a lower FICO score,” said Ethan Dornhelm, principal scientist at FICO.
Another factor at play is length of your credit history. The closure of a longstanding credit card account will also ding your score temporarily.
So how much of a hit will your credit score take should you close a credit card account?
Typically, the impact of a card closure on one’s FICO score is small, notes Dornhelm. And the score can bounce back quickly.
“If a person has important reasons for closing the account, such as a high interest rate or burdensome fees, then the person shouldn’t be overly concerned about their FICO score,” he said. “The person can be confident that her or his FICO score will be fine despite the closure, if they maintain healthy credit habits.”
Still, if you’re planning on applying for an auto, home or other loan where your credit score will be a factor in obtaining the best possible interest rate, you should hold off on canceling any cards until afterward. And once you cancel the card, expect that it will take three to six months for your credit score to bounce back, assuming you don’t do anything else to hurt your score.
If you’re concerned that canceling a card will leave a black hole in your credit file, don’t be. The payment history on a closed account doesn’t vanish, at least not right away.
“One of the myths is that when you close the account you lose the history for that particular card,” Griffin said. When you close an account with no negative history associated to it, Experian maintains that history for 10 years.
In this case, your credit report will say the account was closed at the request of the borrower. That’s not a red flag for lenders, unlike when a card is canceled by the issuer for nonpayment.
When evaluating whether to close out an account you should consider whether the card is helping you financially. Does it have a lower interest rate than other cards? Does it offer incentives or rewards that you value? Is it worth the annual fee you’re paying?
Ideally, cardholders should have a “tight” group of cards that they use on a monthly basis and pay off to keep them active, said Ken Chaplin, a vice president with TransUnion, a credit reporting firm.
Remember the card you signed up for in college in exchange for receiving a free T-shirt? Those cards often had minimal credit limits and relatively higher interest rates. If you’ve been out of school for a decade or more and have since taken on cards with more favorable interest rates and higher balances, consider nixing that old college card.
“It makes sense to prune those,” Chaplin said.