Everything in life is about getting the best compromise out of a situation. The most common compromise people have to face is the one between saving and borrowing. If one indulges too much in the latter, a vicious cycle of debt can start.
In other situations, it may be the case that the conditions for credit card use have ceased to be favorable, compared to other options. Whatever your reason may be, by canceling a credit card, you are removing an accounting resource that determines your credit score. This means that, in most cases, you are not helping your credit score by closing a credit account, even if it is unused.
Nonetheless, canceling a credit card also shuts off potential avenues for accruing debt. To decide the best course of action, you need to understand how credit cards determine your credit score.
What Is A Credit Card?
To figure out why credit cards play an important role in determining your credit, you first need to understand the peculiarities of credit cards as financial instruments. In essence, credit cards reflect the ancient borrowing–lending mechanism from the times when money was represented in the form of precious metals.
Adding plastics and electronics to this age-old mechanism just means it is a more convenient way to borrow money, which is exactly what banks like. The more people borrow, the more interest banks can collect. Every purchase via a credit card obligates you to repay the borrowed money, including extra charges and applicable interest. You may have also noticed that the payment method itself makes products more expensive than if you were to pay using cash or a debit card.
This is because all merchants know that borrowing is associated with risk. People are willing to take this risk because life is a limited resource that keeps draining away. Therefore, instead of saving, most people prefer to borrow so that things are available to them sooner.
Those who pay their credit card bills consistently on time are poised to build a respectably high credit score. Many people decide to use credit cards for this very purpose, in order to prepare their credit scores for a bigger loan down the line. Often, this is related to education, housing, or home renovation.
What Is My Credit Score?
In the US, your credit score is a three-digit number that determines your reliability when it comes to paying your debts. The higher it is, the more financial products and instruments will be available to you. In other words, if you have a high credit score, banks will be more willing to grant you life-changing big loans.
A credit score is also known as your FICO score, after the Fair Isaac Corporation, which first came up with the score-determining formula in 1989. It is used in 90% of interactions when banks and credit unions are deciding a person’s credit-worthiness. These are the credit score ranges:
- 800–850: Amazing credit
- 740–799: Very good credit
- 670–739: Good credit
- 580–669: Not-so-good credit
- 300–579: Poor credit
In conjunction with other factors, such as your income level, length of time employed, and the type of credit you are asking for, banks will determine your credit-worthiness. For mortgage loans, in particular, lenders are very strict about insisting borrowers have a credit score within the upper end of the “good” range. The higher your score, the better the terms of your loans.
In terms of how your FICO score is calculated, the following inputs are considered:
- Recent credit application:10%
- Types of already existing credit lines in use, including revolving credit via credit cards: 10%
- Length of your credit history (longer means a higher score yield): 15%
- Credit utilization (how much debt you have compared to your credit limits): 30%
- Payment history: 35%
Thankfully, your credit score is not a secret. Today, most banks provide free credit score checks. If you have e-banking, simply login to your bank and see it. Otherwise, you can check it from a service such as Experian.
What Is The Relationship Between My Credit Card And My Credit Score?
Because credit cards factor in your credit history, credit utilization rate, and payment history, hurting your credit score is easy if you don’t take precautions when canceling a credit card. In particular:
- If you close a credit card account, it means you have less credit available, which decreases your credit utilization rate — the ratio between your credit limit and how much you have used it. If you have a credit utilization ratio of about 30%, this will boost your credit score. Closing the credit card will remove this factor, thus decreasing your score.
- If you cancel a credit card but have a positive payment history, this important FICO factor will be automatically removed after 10 years. However[.1] , if you close a credit card with a negative payment history, the record will remain for seven years.
What Happens To My Credit Score When I Hold A Credit Card Account For A Long Time?
If you want to boost your credit score, it is best to have open credit lines, including credit cards, for long periods. It’s even better, if you have a couple of open credit cards that have been active for a long time. This accounts for up to 15% of your total FICO score.
When My Credit Card Is Canceled, Does It Affect My Credit Score?
You would only want to cancel a card if you have a negative payment history with it. [.2] This has an immediate negative effect, and in the long run, you are removing a score-boosting resource because your credit length history goes into your FICO score.
How Can I Cancel A Credit Card “Safely”?
Always pay off a credit card’s balance before canceling it. Closing a credit card account with a negative balance — that is, credit card debt — will not wipe out a negative credit report. Moreover, be sure to redeem any credit card rewards you have earned. Lastly, be sure to update any automatic payments you have set up, so no funds are drawn to pay the credit card you intend to cancel.
Canceling a credit card makes sense if the risk of going overboard with it is too high for your liking. It also makes sense if its annual fee or interest rate is too high to make it worthwhile. Likewise, if your credit card has limited terms, such as a student card, it might be worth cancelling.
While canceling a credit card in these cases may be a valid option, keep in mind that your credit score is affected by the total available credit accounts open, and how long they have been open. Therefore, card cancellation could result in cutting off your path to growing your credit score.
Most importantly, pay off your outstanding credit card balance before you cancel it.
Your credit score can have a big impact on your financial future. Sign up for Experian to get your credit score and credit report for free! Join millions of other Americans and get the tools you need to help understand, manage, and master your credit—in under 3 minutes. Checking your credit score with Experian won’t hurt your score.