A listener to the Dough Roller Money Podcast recently sent in a question about credit scores. He wanted to know how canceling a credit card can affect a person’s credit score.
The question comes from a listener named Travis:
I was curious how much closing a credit card can hurt your credit score? I understand that paying your bills on time is a major factor, as well as your C.U.R. (credit utilization ratio) and average age of credit. I ask this question because I have United Explorer Card that I signed up for about 7 years ago, to get their free bonus miles which I ended up not using. I rarely, if ever, use the card and there is $60 annual membership fee. I’m thinking about closing the account and transferring the available credit to my Chase Freedom card, but they are requiring me to keep at least $1,000 credit on the card which will slightly change my credit utilization ratio. I currently have a 3 percent usage according to MINT. Should I suck it up and pay the annual fee or would it be worth the hit to me and to my credit score to not pay the annual fee every year. Thanks in advance. Keep the podcasts coming.
First of all, congratulations to Travis for considering his options for closing out the account. People often close out credit lines, giving little consideration to the impact that it might have on their credit scores.
Listen to this Q&A in our podcast
Yes, Closing Out a Credit Line Can Hurt Your Credit Score
On the surface, closing a credit card appears to be a positive step. After all, you’re eliminating yet another obligation, as well as another account that needs to be managed. And by closing out the credit line, you also remove the temptation to buy things that you can’t afford. How can any of that be a bad thing?
It all comes down to the credit utilization ratio, just as Travis mentioned in his email. The CUR comes into play with revolving credit, such as credit cards and a home equity line of credit. It is the amount of your available credit – by percentage – that you actually have due and outstanding.
For example, let’s say that you have two credit cards, each with a $2,500 credit limit. You owe $500 on one, and have a zero balance on the other. You can determine your credit utilization ratio by dividing the $500 that you owe on one credit card, by the total credit limits of both cards, which is $5,000. In this example, your credit utilization ratio will be 10% ($500 owed, divided by your combined $5,000 credit limits).
How Closing Out a Credit Line Will Hurt Travis’s Credit Score
Continuing our example, if you close out the credit line that has no balance on it, your total available revolving credit limit will drop to $2,500. Now when you divide the $500 outstanding balance on the remaining card by your available credit, the credit utilization ratio will increase to 20% ($500 divided by $2,500). That will represent an immediate doubling of your credit utilization ratio.
The lower your credit utilization ratio, the better. As your credit utilization ratio increases it can have an negative affect on your credit score. As your credit utilization ratio moves higher, and especially as it gets close to 100%, you become increasingly “maxed out.” In that case, you are considered to be a higher risk for default on your loans.
So What is a “Good” Credit Utilization Ratio?
We know that the lower the credit utilization ratio the better. But when does this factor begin to hurt your score? It’s an important question, but one without an exact answer.
The good folks at FICO don’t tell us exactly how a higher credit utilization will hurt our score. They tell us it’s an important factor and that a lower utilization ratio is better than a higher one. But they don’t give us precise details. That’s the bad news.
The good news is that they have given us some additional guidance. I had the pleasure of interviewing Tom Quinn about a year ago. Tom is the credit expert for FICO, and arguably one of the most knowledgeable experts on FICO scores you’ll find anywhere. He said that ideally we should keep are credit utilization somewhere between one and 20%.
He covered a number of other topics, which you can listen to in this podcast.
Strategies to Considering When Canceling a Credit Card
- Transfer the credit to another card from the same issuer: Travis alluded to this in his email. Many credit card issuers will allow you to cancel one card and transfer the available credit over to another card you have with the same issuer. I’ve done with with Citi in the past. The result is that your total credit limit stays the same.
- Ask the issuer to waive the annual fee: While this is not a permanent solution, many credit card issuers will waive the annual fee for a year rather than losing a customer. In fact, every time I’ve closed a card with an annual fee they’ve made this offer as a way to keep me from canceling the card.
- Apply for a no fee card, and then cancel your annual fee card: Assuming that the credit you get on the knew card is the same or higher as the card you want to close, your available credit won’t go down. Keep in mind that applying for a new card does result in a hard pull on your credit report. While this can lower your credit score, at least for a time, it’s not as significant a factor as your credit utilization.
- Don’t do anything if you are about to apply for a mortgage: Finally, if I were about to buy a home or refinance a mortgage, I wouldn’t do ANYTHING that could possible hurt my score. Even small changes to a FICO score can raise the interest rate on a new mortgage. As a result, I would close on the mortgage first before dealing with a credit card that has an annual fee.
Finally, if you don’t know your credit score or credit utilization, you can get that information directly from the folks at FICO.