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When people pay off debt, many of them rush to close credit card accounts. Indeed, the process can be quite therapeutic. You pay off a credit card, and, to celebrate your freedom from the chains of the debt (and being on the wrong side of compound interest), you cut up the card and cancel the account.
Unfortunately, this may not be the right thing to do — at least as far as your credit score is concerned. If you are interested in maintaining your credit score, you might want to think twice before canceling that credit card. Your credit could be damaged by a canceled credit card account.
What the Credit Industry Really Wants
You know that in order to get loans at a decent interest rate, you need a good credit history. However, the credit system is not set up to reward responsible financial behavior. Instead, the credit system is set up to reward the use of credit. The main goal of the credit industry is to encourage you to get in a position where you are carrying debt so that you pay interest, but not so that you are in over your head. Credit card companies want you to be able to pay.
Canceling a credit card does not help the credit industry, and so there is a way for you be penalized for making such a move. Remember: To a credit card company, the best customer is not someone who pays a balance off every month. The best customer is someone who carries a balance that he or she can make payments on without going financially under.
Canceled Credit Card = Lower Credit Score
For most of us, playing the credit game is a necessary evil, especially since it’s not just mortgage lenders looking at your credit score. Some insurers will quote you higher rates if you don’t have good credit, and some employers might want a credit check as part of background screening. It may not be fair or right, but it is reality.
When you cancel a credit card, something happens to what is known as your credit utilization. Your credit utilization is a representation of how much of your credit you are using. It accounts for about 30% of your credit score. After payment history, credit utilization is the most important aspect of your credit score.
Let’s say you have three credit cards with a combined credit limit of $12,000. For simplicity’s sake, we’ll say that you have a $4,000 limit on each card. You are carrying a balance on two of the cards, $1,500 on each card, for a total of $3,000. At this point your credit utilization is 25%, which isn’t bad. In fact, anything in the range of 20% to 30% is considered just fine, and doesn’t really affect your credit score negatively. (Of course, for your own personal finances, it would be best to have 0% credit utilization, but the credit industry doesn’t actually want that.)
However, if you cancel the credit card that you don’t have a balance on, the whole equation changes. Now, instead of having three credit cards with a $12,000 limit, you only have two credit cards with a combined limit of $8,000. Suddenly, that $3,000 you still have as a balance represents a credit utilization of 37.5%. You are moving into dangerous territory as far as your credit score is concerned.
When to Cancel Your Credit Card
Of course, your credit score can recover. However, it is a good idea to consider waiting to cancel your credit card. Your best bet is to wait to cancel your credit card until the following conditions are met:
- You have paid off your other credit cards as well.
- You don’t plan on applying for credit (especially a home mortgage) in the next six months.
- You are unlikely to have a major life change, such as switching jobs, in the near future.
- You’re insurance premium for the next six months has just been established.