In the comments section of a prior post about large interest rate increases by banks and credit card issuers, Vikki, a reader asked:
"Doesn't closing your credit cards bring down your credit score? This is the only reason why I haven't closed my cards... just paying them off and not really using them."
Vikki asked a great question, which I want to answer more completely. We all have felt "mugged" by the recent large interest rate increases, credit limit decreases, or both -- especially when you have an excellent payment history. The temptation -- or reaction -- is strong: to close the credit card account. Regardless, you don't want to make a bad situation worse by closing a credit card account and later learn that it was a mistake.
To learn more about credit scores, I spent some time reading the MyFICO.com Web site, which is run by the Fair Isaac Corporation, the same company that ownes the FICO score formula. At the Web site, you can learn about the factors your credit score includes and the factors your credit score excludes.
The site also has a page about whether closing a credit card account will negatively affect your credit score. A decision to close a credit card account should consider:
- The outstanding balance amounts on your credit cards
- How much of those balances you can pay off now
- The interest rates on your credit cards
- Your "utilization rate" -- how much of the total available credit you use with your credit cards
- The annual fees on your credit cards
- If you will need credit in the near future
- If you have several credit cards, which credit card account you want to close
Your utilization rate is important. It is one of the factors used to calculate your credit score. A high utilization rate will negatively affect your credit score. For example: closing a credit card with a $5,000 limit means you would have $5,000 less in available credit. If you have two credit cards each with a $5,000 credit limit and you owe $2,500 on your second card, then your utilization rate went from 25 to 50 percent. That would negatively affect your credit score.
Only you know whether or not you will need credit in the near future. If you plan to buy a house or a car soon, then you will probably need credit unless you can pay with cash. If you close a credit card account and that results in a lower credit score, then it could cost you more money on your new loan.
The MyFICO site has data tables that show the impact of a lower credit score. For example, if your credit score dropped 15 points -- say from 770 to 755 -- it could result in a higher interest rate and monthly payments on a 36-month auto loan. You can view data tables with credit scores and corresponding interest rates and monthly payments for auto loans, mortgages, and home equity loans.
Over at the Red Tape Chronicles blog, Bob Sullivan summed up the problem facing consumers:
"No one can say precisely how much closing a credit card account will hurt your credit score -- too many other dynamic factors go into calculating the number. Fair Isaac, which owns the credit score formula, says the impact can range from zero points to dozens of points..."
If you decide to stop using a credit card instead of closing that credit card account, then your decision could have negative consequences. Some consumers have reported that their bank or credit card issuer (e.g., HSBC, Citibank, American Express) has closed unused credit card accounts, often without notice. That credit card account auto-closed by your bank could drive up your credit utilization rate and negatively affect your credit score. So, check the fine print in your card agreement before you stop using a credit card.
After reading the MyFICO Web site, I remembered some credit decisions I made about 12 years ago, At that time, I had five credit cards with a combined outstanding balance of $18,000. For me, I had too much credit card debt and it had become unmanageable. I didn't need more credit and didn't want any more credit. 12 years ago, the Internet then wasn't the robust research source it is today. I met with a credit counseling agency to get some sound advice. What worked for me: I closed three credit card accounts, negotiated a lower interest rate on one card, halved the credit limit on one card, stopped paying off old credit card balances with new cards, stopped using my credit cards for cash advances, and paid off the highest interest rate card first. I didn't consider the negative impact on my credit score. I was focused on the benefits of living debt free with less stress.
In time, I was able to pay off all of that credit card debt. Today I have zero credit card debt and a credit score above 790. I had it easier than many people since the interest rates on my credit cards were not as high as the outrageous 29.9% today on some credit cards. Today, I pay off my credit card bills in full and on time each month to avoid finance fees. The two credit cards I have are manageable. If either of these cards raise their annual fee in the future, I will switch to another low-annual-fee card and close the offending card account.
Basically, the decision to close a credit card account depends upon your situation. The closed credit card account would be a reduction in credit that could have a big impact on your credit score and on your finances. Make the decision that best benefits you.