Discussions about credit improvement often focus on the dos. However, in many cases, the don’ts are just as important.
For example, I was lurking on one of my favorite personal finance forums the other day and came across this question:
“Paid off one of my credit cards the other day and my credit score dropped 15 points. What’s the deal?”
I had to jump in.
“Did you close the card? How many credit cards do you have?”
“Yes. Three, now two.”
I can almost guarantee that closing the credit card did a little doozy on his credit score.
Warning! Closing a paid off credit card may not be the best idea.
Check Your Credit Report
[Free Resource: Check your free credit report and score]Before canceling those paid off, old or unused credit card accounts, review your credit report.
If you’re actively paying down debt, you probably already have your credit report handy. If not, or you just want to get a handle on what old and unused credit card accounts you might have out there, grab your free credit report from Quizzle. As you’re reviewing your credit report, compile a complete list of all your credit card accounts, outstanding balances and total available credit (i.e. total of credit limits).
In addition to compiling this list, check to see if there are any credit card accounts that you’re unfamiliar with or if your creditors have reported any inaccurate information. It wouldn’t hurt to do this monthly since creditors report new information every month.
Understanding Credit Utilization
Once you have your list of credit cards, outstanding balances, and total available credit, I want you to do a little figuring:
- For each credit card account, take the outstanding balance and divide it by your credit limit, then multiply by 100. This will give you the percentage of credit utilization on each credit card.
- Now add up all of your credit cards’ outstanding balances and add up all your credit limits. Then do the same calculation you did in step one: divide the outstanding balances by the credit limits, then multiply by 100. This will give you your total percentage of credit utilization for all credit cards.
Take a look at this example:
Your individual credit card utilization rates and total credit card utilization rate are critical components of your credit score, as 30 percent of your credit score is related to the amounts you owe. Specifically, we are analyzing the proportion of credit lines used.
Now, here is your first don’t…
See how closing the two paid-off credit cards in the above image jumped the credit utilization from 42.50 percent to a whopping 75.56 percent? This would very likely negatively impact a credit score. This is why you need to consider carefully before closing paid off credit cards.
Reasons to Close Credit Card Accounts
Having said that, there are very legitimate reasons to close credit card accounts. Here are a few of the biggies:
- Retail or secured credit cards - Not all credit cards are created equally. Retail and prepaid credit cards are generally considered by lenders as less desirable credit. Therefore, if you have sufficient credit history and lower utilization, you may want to begin clearing these off your credit report.
- Identity theft prevention - If you have several old and unused credit cards, you may begin to forget about them and even neglect to look at the statements. This can be very dangerous, as these become prime targets for identity thieves. Either close them or get monthly credit report updates to keep an eye on these accounts.
- Debt control - If you’re having trouble with debt, credit cards with unused balances may simply be too much temptation. It’s better to take a ding on your credit score than to slip back into debt problems – close them.
Closing Credit Card Accounts
If you do decide to close a credit card account, keep in mind these tips to optimize your credit history and minimize any damage to your credit score.
More dos and don’ts of closing credit card accounts:
- Avoid closing your oldest credit card account - This may make your credit history appear shorter as closed accounts eventually drop from your credit report.
- Keep tabs on your credit report - Verify that the account is reported as closed on your credit report and that any final reporting by the creditor is accurate. This is especially important when closing a credit card account that isn’t paid off. The creditor may inadvertently stop reporting your future pay-downs or payoffs.
- Maintain three to six open credit accounts at all times - These do not all have to be credit cards. In fact, it is preferable to have a mortgage, auto loan, or other types of good credit accounts mixed in.
Getting credit card debt under control is an awesome feeling. Just remember, as you’re managing your credit, balance the practical elements of staying out of debt with the statistical elements that credit bureaus use to calculate that all-important three digit number.
Do you have any questions about credit utilization or how closing credit card account impacts your credit score? Leave a comment and we’ll do a little Q&A.