You’ve worked hard and finally paid off the balance on one of your credit cards. Now, you should go ahead and pay off the balance and cancel the card, right?
You should think twice before canceling a paid off credit card. Closing a credit card account will negatively impact your credit score, especially if you’ve held the credit card for a long time.
Also, if you are about to apply for a loan or mortgage, a recent credit card cancellation could actually hurt your chances of qualifying.
There are two main ways that cancelling a credit card can hurt your credit score:
Number One – Cancelling a Credit Card Can Raise Your Ratio of Credit Card Utilization
Credit bureaus compare the amount of credit that you are using to your total available credit limits. In fact, credit card utilization accounts for up to 30% of your credit score. The lower your credit card utilization figure is, the better it is for your overall credit score. It’s best to keep your credit utilization ratio below 20%. If you cancel a credit card, then you are increasing the percentage of available credit that you are using because the credit limit for that card is cancelled too.
For example: Imagine that you have three credit cards with a $2,000 limit on each of them. On card number 1, you have a $600 balance. On card number 2, you have a $500 balance. On card number 3, you have a $50.00 balance. Your credit card utilization ratio is averaged across the three cards, so it would be ($600 + $500 + $50)/$6000 = $1150/$6,000, or a healthy 19% of your available credit.
However, let’s say that you decide to pay off card number 3 and cancel the card. Your credit utilization ration, now averaged across two cards, would now be ($600 + $500)/$4000=$1100/$4000, or about 28% of your available credit. Closing a credit card account caused your credit utilization score to jump quickly from an acceptable range (19%) to an unacceptable range (28%).
Number Two – Cancelling a Credit Card Affects Your Credit History
When it comes to your credit score, older debt is better than new debt. That’s because loan companies want to see that you have a long history of managing debt well. In fact, the length of your credit history accounts for up to 15% of your credit score. If your card history for a particular card shows a consistent pattern of payment over a long time, then usually you are much better off keeping that credit card account open.
What to Do Instead of Cancelling a Credit Card
Let’s say that you finally have a credit card almost paid off. A natural impulse would be to completely pay it off and close the credit card account. As we have shown, however, this may not be the best overall choice for your credit score.
An alternative to closing an account is to leave the credit card account open, but to make no new charges on it. (If you feel that the temptation to make new charges is too great, then you may wish to hide the card away to avoid using it.)