A couple of days ago, I addressed the importance of making on-time credit payments. Your payment history accounts for about 35% of your FICO credit score. However, payment history is closely followed in importance by your credit utilization. Your credit utilization accounts for about 30% of your credit score. This means that if you want to have a good score, you will need to pay attention to how much of your available credit you are using.
What is Credit Utilization?
Credit utilization is basically the amount of credit you are using. It can be expressed as a percentage. If your limit on a credit card is $2,500, and you have a balance of $1,000, your credit utilization is 40%. You are using up 40% of your available credit. Your credit score takes into account all of these types of accounts, and adds up your balances, and figures out your credit utilization. The higher your credit utilization, the lower your credit score. Indeed, if you are close to the maximum on all of your credit cards, you will find it difficult to make headway in improving your credit score.
Why Closing a Credit Card Account Can Hurt Your Credit Score
The emphasis on credit utilization helps explain why it can hurt your credit score to close a credit card account. First of all, it is important to understand that your credit score measures how you use credit. If you are closing accounts, you can’t be using credit. But there are more practical reasons behind the drop in your score when you close a credit card account.
Let’s say you have three credit cards:
- Credit Limit: $4,000 Balance: $3,000
- Credit Limit: $2,500 Balance: $500
- Credit Limit: $2,000 Balance: $0
You decide that, since you have paid off Credit Card #3, you are going to close that account. Before you close the account, you have a total credit limit of $8,500. You are using $3,500 of that, so your credit utilization is 41%. Now, when you close Credit Card #3, you suddenly only have a total credit limit of $6,500 — but you still have $3,500 in credit debt. Your utilization just jumped to 54%. That jump can mean a lower credit score, since credit utilization is weighted so heavily in the formula.
Careful Consideration Before Canceling Your Credit Cards
Before you cancel a credit card, you need to carefully consider what you are doing. If you plan to apply for a loan any time soon, it is probably not the best idea to cancel your credit card. If you do so, the drop in your credit score could result in you paying a higher interest rate, costing you hundreds — or even thousands — of dollars over the life of your loan.
On the other hand, if you are confident that you won’t have need of credit in the next few months, it might not be so bad to cancel your credit card, as long as you are aggressively paying down your other credit card debt so that can improve your credit utilization going forward. Carefully examine your goals, and determine which course of action is likely to be of most benefit to you.
Image source: Lotus Head via Wikimedia Commons