Many people struggle with the idea of if they should close a credit card or not after they pay it off. There are many reasons as to why people think this is a smart thing to do. Some get the advice from experts of the past that used to preach this philosophy as if they just cracked the secret code to the FICO system. Other people try to add common sense as the logic behind why they should close their credit cards. Some people actually give the right advice but just by dumb luck. Let me clear this confusing topic up once and for all by digging a little deeper into this question so that next time you are faced with this dilemma you will know what the best thing to do is.
Just to be clear for 99% of the people out there…do NOT close the account! Now here is why: when it comes to your credit score every action you make can affect multiple areas of your score. We want to be careful to not do something that will positively affect one part of your score but hurt two other parts. When you close an account there are three components of your score that will change. Those are: mix of credit, average age of credit and debt ratio. Let’s evaluate these in order.
1. Mix of credit- this makes up 10% of your FICO score. This is referring to the different types of credit that you have open and active on your report at any moment in time. Your score likes to see a diverse mix of accounts. If fact the best way to maximize the points in this category is to have a mortgage account, some other type of installment account (auto loan, student loan, etc) and three to five credit cards. One of the reasons that people are fooled into thinking it’s a good idea to close a credit card account is usually because they have more than 5 open credit cards and closing one of them will help to get them to the proper number of suggested cards. Logically this might make sense but if you understand more you will see that closing one account to potentially improve part of a category that only makes up 10% of your score is not enough of a reason to close it. This would be like stepping over a $20 bill to pick a $1 bill; doesn’t make a whole lot of sense, just like this action wouldn’t make a lot of sense.
2. Average age of credit-many self proclaimed experts of credit will now tell you that the reason you shouldn’t close your credit card account is that if you do you will “shrink” your age of credit. In case you’re not aware, the average age of credit makes up 15% of your credit score. This number is calculated by averaging the number of months all of your accounts have been open; the longer the better. Just for the record closing an account doesn’t shrink your average age of credit; if the account is on the report it is still a “score-able” account. Just because you close the account doesn’t mean that it gets removed from your credit report. I agree that if the account is closed it takes away from the ability of the account to continue to get older, but the current average age of credit doesn’t shrink just by closing the account.
3. Debt ratio-this calculation has nothing to do with how much money you make; this is calculating a percent of credit being used based on the current limits of your credit cards in comparison to your balances owed on your cards. Your debt ration makes up 30% of your FICO Score. To help make this easier to understand let’s assume that you have two credit cards. They both have a limit of $1,000 and one has a balance of $500 and the other has a $0 balance. In this scenario you have $2,000 in total limits ($1,000 + $1,000) and $500 in combined balances ($500 + $0). This would equate to you having a debt ratio of 25% ($2,000/$500) or in other words you are currently using 25% of your available credit. It is important to understand the lower this percentage is the better it is for your score. Ideally it is best to have this be less than 10% to be safe and to maximize this part of your score. Now let’s assume that you for whatever reason decide to close the one account that has a $0 balance. If we redo this math you will see that you now have $500 in balances owed and $1,000 in limits which means our debt ratio just went from 25% to 50% ($1,000/$500). This is bad and this ladies and gentlemen is the real reason why you don’t want to get a wild hair and close credit cards that you are not using or that you have paid off. Based upon the weight of this category it is important for you to do whatever you can to keep your ratio low.
Hopefully this will help you better understand why closing a credit card account is not a wise tool to use when trying to improve your FICO score. As an added bonus by reading and understanding this article you now know more than many of the self proclaimed credit experts out there. (click here for a free consultation on how to improve your credit score)