That moment, when you FINALLY pay off a credit card that has plagued your thoughts and haunted your monthly bottom line for years, or even decades, can be a moment when you want to tell the company good riddance and leave them behind forever. But, is that the right move to make for your credit score?
While there is a knee-jerk reaction in financial circles to warn that old accounts carry merit when it comes to credit scores, there is also the fact that some people have difficulty resisting the temptation of the blank slate a paid-off credit card represents.
Anatomy of a Credit Score
Before you dig in too deep, it’s wise to explore the anatomy of a credit score, and how a closed credit card can affect your score.
Your credit score consists of five parts:
- Payment history
- Amount owed
- Length of credit history (how long accounts have been open)
- A mixture of credit types (home and car loans vs. credit cards and revolving credit accounts — HINT, you want more of the first)
- New credit
The problem represented by closing a credit card, which will impact your score to some degree, for better or worse, isn’t with the credit score, though. It is with another factor lenders view: credit utilization scores.
What is Credit Utilization and How Does It Affect Your Credit?
Beyond your credit score, lenders look at your credit utilization. It isn’t part of your credit score, per se, but does affect a lender’s willingness to extend credit.
What is credit utilization? It’s a term that describes how much credit is available to you vs. how much credit you’re actually utilizing.
That means your credit utilization on your recently paid off credit card is zero percent, meaning you’re utilizing zero percent of the balance available to you on that card. If it’s a high-value card, say $5,000 or more, that can help you improve your credit utilization score.
Lenders typically prefer this number to be 25 percent or less utilization. To them, that says you can manage your credit wisely and aren’t constantly pushing the limits of your available credit.
Hypothetically, if you have the following credit cards:
- $5,000 spent with a $10,000 credit limit. (50% credit utilization score)
- $3,000 spent with a $5,000 credit limit. (60% credit utilization score)
- $0 spent with a $3,000 credit limit (0% credit utilization score)
Combined, your total spent would be $8,000 on an $18,000 credit limit. Your credit utilization with the recently paid off card would be 44.4 percent ($8,000 divided by $18,000). If you close the recently paid off card, however, the numbers change. Your new credit utilization ratio would be 53.3 percent ($8,000 divided by $15,000), taking you further away from the goal of 25 percent for optimal borrowing capabilities.
Remember, your goal should be to have a credit utilization ratio below 25% — meaning you only spend 25% of your available credit limit. Closing a credit card with a high limit may lead your credit utilization ratio to increase and cause lenders to hesitate on providing you future credit.
In most cases, it is best to forget you have the card but keep the account open, to help improve your credit utilization score. However, if you cannot resist the temptation not to spend or you have a high annual fee, you might be better off closing the account.
We’re Here to Help!
Our goal at the credit union is to help you make the best financial decisions for your unique situation. If you have questions on improving your credit score, email us at firstname.lastname@example.org or give us a call at 202-479-2270.