Update: After feedback from readers, I've made some clarifications to this post. My recommendations have not changed, but I've tried to emphasize the effect closing a credit card can have on your credit score.
My recent two-part series on responsible credit card use (Five essential credit card skills and How to choose a credit card) prompted several readers to ask the same question: What's the best way to cancel credit cards in order to minimize the impact on your credit score? I spent an afternoon doing some research — here's what I learned.
Anatomy of a credit score
If you use credit in the United States, you have a credit score. You rent an apartment, buy a house and a car, pay utility bills, and sign up for the best credit cards. As you spend, banks and landlords and other agencies report your habits to credit bureaus, organizations that collect this information in centralized databases. This data is then converted into credit reports and, ultimately, into a credit score.
Your credit score is a single number that measures your creditworthiness, and determines the types of credit you can obtain, and how much this credit will cost you. In general, your credit score is based on the following:
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According to Fair Isaac, the company behind credit scores, these factors are accurate predictors of future credit performance. That is, these are the things that best indicate how great a credit risk you are. (For some people — such as young adults who don't have a lengthy credit history — the importance of each category may be somewhat different.)
For more detailed information about the components of your credit score, check out myFICO.
Pros and cons of canceling a credit card
On the surface, closing an unused credit card account seems like a no-brainer. It's not. Closing a credit card account may actually hurt your credit score on two levels.
- The longer you've had an account, the more weight it carries. That's part of the “length of credit history” slice in the pie chart above.
- The “amounts owed” slice represents the balance and burden of your credit, how much of your available credit you use. Say you have two cards, both with $5,000 limits. You're carrying a $2,000 balance on one of the cards, or about 20% of your total available credit. If you close the unused card, you'll then be using 40% of your available credit, and your “utilization ratio” will jump, giving a temporary ding to your credit score.
After speaking with the consumer affairs manager from Fair Isaac, Bankrate concluded:
If your credit card balance is zero, go ahead and close as many unused accounts as you want. As long as your credit cards are balance-free, it won't hurt your credit score a bit. So call those card issuers and cut away.
If you're in credit trouble or if you had credit problems in the past and you know an open credit line is just going to temp you to spend — go ahead and close the account. Yes, it might ding your credit score a bit. But if it will keep you from acquiring more debt, it's best to do it.
This quote from Bankrate is a little misleading. While it's true that keeping credit cards balance-free will prevent your credit score from being hurt if you close an account, the only way to keep the cards balance-free is not to use them. Even if you pay off your cards every month, the issuers still report a balance to the credit agency. As a result, canceling an account can drop your credit score. (And I'm under the impression it can never raise it.)
There are several arguments for closing your unused credit card accounts, however. Doing so:
- Reduces the risk of identity theft.
- Reduces your bookkeeping.
- Prevents you from abusing them.
- Puts you in control of your finances. (Don't underestimate the power of this.)
Whether these factors outweigh the potential damage to your credit score is for you to decide. When I was struggling with debt, I canceled my accounts, and I'm glad I did. It gave me time to learn about money without the temptation to spend. Now that I can manage my finances responsibly, I've obtained one card. My FICO score is 814.
There's at least one situation in which you should keep your accounts open, though. If you intend to take out a major loan in the next year (like an auto loan or a mortgage), do not cancel your accounts. Doing so will ding your credit score, if you're carrying a balance. Instead, freeze your credit cards in a block of ice, or place them in a safe deposit box.
If you plan to close several accounts, do one at a time. When choosing which accounts to cancel, first eliminate cards that charge you fees. Cancel new cards before old cards. (Remember: the age of the account affects your credit score.) Consider keeping cards that offer good rewards programs.
Before you cancel a credit card account, pay off the balance or transfer it elsewhere. Never attempt to cancel an account on which you still owe money. I've heard horror stories of banks raising interest rates on people who do this.
When you're ready, follow these simple steps:
- Call to cancel the account. Check with customer service to be sure your balance is zero before you start the process. After you ask to cancel your card, the sales rep may try to talk you out of it. Be prepared to stand your ground. And take notes!
- Send written confirmation. Using your notes, write a letter and send it to the card issuer. You can find a sample credit card cancellation letter at The Dolans.
- Check your credit report. After you receive confirmation that the card has been canceled, it may take several weeks for the change to be reflected in your credit report. It is your responsibility to verify that your report is accurate, so keep tabs on it.
Once you're certain the account is closed, cut up your card! Hurrah!
Should you cancel your credit cards? Only you can make that call. Do what makes sense for you and your situation. If you think it's more important to maintain your credit score, and if you're sure you won't abuse them, then keep the accounts open. But I think it's a mistake to keep your credit cards if they cause you woe.
If you have trouble with compulsive spending, it's best to cancel your accounts. Don't just cut them up, but cancel them. Here's a recent reader comment that reveals why sometimes cutting up a credit card isn't enough — you have to cancel the account. When I was having trouble with credit, I canceled my accounts, which bought me time to learn to manage money responsibly without an ever-present temptation to spend.
Update: Here's a great discussion of this subject at the myFICO forums. Also, Subodh has some credit tips based on his experience (as opposed to the “official” word, which is what I've tried to dig up to share here).
Photo by Shuttercat7.