An overwhelming amount of credit card debt is an issue for many Americans. The financial stress it can bring about in your life is not worth the headache. Which is why so many borrowers are choosing to minimize their debt or eliminate it altogether to live a lifestyle in pursuit of financial freedom. A significant benefit of paying off your credit card debt is improving your credit score. However, there are certain actions that might cause a temporary drop in your credit score on the road to financial freedom.
Can closing a credit card hurt your credit score while you are paying off debt? This question and others like it are important to ask as you eliminate credit card debt because it’s crucial to monitor the state of your credit report while you make big financial changes. Credit scores go beyond loan and credit card applications, as they can be used by employers, landlords, and insurance providers as well.
Reducing your overall debt is going to do wonders for your credit score and there are several tricks you can employ to prevent unnecessary temporary drops in your credit while you work towards financial freedom.
What’s Included on Your Credit Report?
To get a better understanding of what affects your credit score and why, it is a good idea to learn what is included on credit reports and how that information impacts the calculation of credit scores. Once you have a clear understanding of what makes up your credit report, you will intuitively know what could harm your creditworthiness.
There are three major credit reporting bureaus that credit card issuers and lenders pass information to—TransUnion, Experian, and Equifax. These three credit bureaus compile consumers’ credit reports containing information deemed relevant to your overall financial reliability and broken into the categories of personal details, credit accounts, credit inquiries, public records, and collection accounts.
Personal Details
The personal details section of your credit report serves the purpose of connecting you to your file. This identifying information does not factor into the calculation of your credit score. Basic details will likely include full name, date of birth, previous and current addresses, Social Security number, phone numbers, and possibly employment information.
Credit Accounts
The most significant portion of your credit report is taken up with all important information relating to your credit accounts. Details of your credit accounts will include the type of account (credit card, installment loan, payday loan, auto loan, mortgage loan, student loan, etc.), date you opened the credit account, the credit limit or loan amount, the account balance, and each account’s payment history. All closed credit accounts drop off of your credit report after a certain amount of years have passed.
Credit Inquiries
Every time that you apply for new credit, you are authorizing the credit card issuer to pull a copy of your credit report. Each time this happens, a new hard inquiry will appear on within the credit inquiries section of your report. Too many hard inquiries can negatively affect your credit score and remain on your report for up to two years. Soft inquiries, on the other hand, do not impact your score as these are a result of pre-approval offers and checking your own credit.
Public Records
Each credit bureau will note any and all public records from state and county courts that are relevant to your creditworthiness. Public records that might be in your credit report include foreclosures, repossessions, and bankruptcy filings.
Collection Accounts
When an unpaid debt is sold to a debt collection agency, the creation of new collection accounts will show up on your credit report. All collection accounts will appear as derogatory marks that negatively affect your credit score.
Could Closing a Credit Card Account Hurt Your Credit?
In many circumstances, closing a credit card can have a direct impact on your credit score. Your credit score points might initially decrease directly after canceling credit card accounts. However, it is likely your credit score will bounce back to it’s original state after a couple of months as long as you keep up responsible credit use.
For this reason, many financial experts recommend not closing credit cards if you plan to apply for additional credit any time soon. The main reasons why you might see a decrease in your credit score after closing a credit card is because of changes in your credit utilization ratio and the average age of your credit history.
Credit Utilization Ratio
Your credit utilization ratio has a significant impact on the calculation of your credit score. It represents your credit card balances compared to how much available credit you have on all your credit card accounts. The ideal is to keep your overall credit utilization relatively low so you have substantially more available credit than used credit.
Closing a credit card causes the percentage of credit you are using to jump higher as you just minimized the amount of total available credit you have by canceling the card. For example, let’s say you had a credit card with a $3,000 credit limit with a $0 balance. The minute you close that card, your total available credit decreases by $3,000 dollars meaning the percentage of available credit you are using goes way up.
The lower your credit utilization ratio, the better for your credit score. Most financial experts suggest a rate under 30% for an optimal credit rating. This is one of the foremost reasons why borrowers experience a drop in their score with a closed credit card.
Age of Your Credit History
The second reason that closing a credit card affects your score is that it could decrease the average age of your credit card accounts. The length of your credit history accounts for 15% of your credit score calculation. A more established credit history requires older accounts to bring up the average age of your credit and longer payment histories.
This isn’t as big of an issue as your credit utilization ratio could be, as a closed credit account will still remain on your report and be factored into your credit score for up to ten years.
When Closing a Credit Card Is Necessary
Even though it is usually a good idea to keep your paid off credit card accounts open for a while, there are some circumstances where it closing a credit card makes sense. Some examples of times in which it makes more sense to close the credit card rather than leave it open include:
- There is a high annual fee, and you don’t wish to continue using the card so the costs aren’t worth it.
- You are unable to resist the temptation of using the card to spend money you don’t have.
- There is a high-interest rate on the card, and you are required to carry a balance.
- You want to upgrade to a rewards credit card that offers better benefits.
How to Safely Close a Credit Card Account
While your credit score will likely rebound after the temporary drop when closing a credit card, it is still a good idea to take precautions to reduce potential harm. If at all possible, pay off the outstanding balance fully before closing the credit card account. For rewards cards, make sure there are no remaining rewards to redeem so that they don’t go to waste.
Before canceling the credit card, stop any automatic payments connected to the account so you don’t get any failed transactions. Contact the credit card issuer and request that your account be permanently closed. After you’ve received confirmation from the credit card company, you can destroy your credit card using a shredder or cutting it up into small pieces with scissors.
When To Leave Credit Card Accounts Open
There are certain situations where you should not cancel your credit card right away, if you can help it. Doing everything you can to keep your credit utilization ratio low to demonstrate responsible credit usage is crucial to a healthy credit score. Here are a few examples of circumstances in which you will want to leave your credit card account open for a while longer:
- You are planning to apply for important credit soon, such as an auto loan or a mortgage.
- The credit card you are considering canceling is the oldest or one of the oldest accounts on your credit file.
- You don’t have that many other credit card accounts open at this time so closing this account would greatly diminish your total credit limit.
- The other accounts you have open have a high credit card balance approaching their credit limit. Canceling a card with more available credit when your other accounts don’t have much available credit could seriously damage your credit utilization ratio.
- Your only reason for wanting to cancel the card is because you don’t use it very often. Without a specific purpose for closing the account, it’s a good idea to leave it open.
Tips To Avoid Closing a Credit Card Account
If you do decide to keep your credit account open a while longer to maintain your credit score, there are several things you can do so the open card isn’t a nuisance to you.
For those who are concerned that they might be tempted to overspend using the card, it’s not necessary to carry the credit card with you. You can hide it in your sock drawer or even freeze it in a block of ice so you won’t use it regularly.
Some credit card companies require borrowers to carry a balance for them to not cancel the card themselves. A simple solution to this problem is to set up a small recurring charge to this card. Something minor like your Netflix or electricity bill could be perfect. Set up an automatic payment and then pay off the balance directly after so you don’t have to deal with any pesky interest charges. You can stop using the card altogether, only remembering it once a month to pay off that one charge.
References:
Will Closing a Credit Card Hurt Your Score? | Experian
Does Closing A Credit Card Hurt Your Credit Score? | Forbes Advisor