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Most Americans have multiple credit cards, while the majority hold 3-5 credit cards, some have as many as 10-12. Few people really need that many credit cards; for the most part, the cards are left-over relics from the days when lucrative no-fee 0% APR offers flowed like milk and honey.
In the changing credit card environment, however, it could soon get costly to have too many credit cards. Some card issuers are reintroducing annual fees and other fees linked to card usage, which could quickly turn unused credit cards into a liability.
However, simply cancelling unused credit cards isn’t that straightforward either. Most experts advise against closing credit card accounts, because it may lower your FICO score. In particular, cancelling a credit card could affect your credit utilization ratio, a measure of how much credit card debt you carry in relation to your total credit available. It could also shorten the length of your credit history, another component of FICO scores.
However, while the overall caution against cancelling credit cards is well-founded, it is not a one-size-fits-all advice. Depending on the specifics of your personal financial situation, closing inactive credit cards might not affect your credit score, or could affect it minimally, as long as you go about it correctly. Here are some tips to minimize the effects of closing credit cards.
1. Pay down credit card debt first
The best way to minimize the impact of closing a card involves maintaining a healthy available credit-to-debt, or utilization ratio. In general, the drop in your credit rating from canceling a card will run proportional to the increase in your utilization ratio. To avoid impact on your credit score, keep the utilization ratio below 30 percent, and ideally at around 10 percent.
To get a sense of how much closing a card would affect your credit utilization ratio, total the credit limits among all your cards, then divide it by the total balance you typically have outstanding each month. For example, if the total credit limit across all cards is $20,000, and the typical monthly balance on all the cards is $2,000, the credit utilization score will be 10 percent, which is considered within the ideal range for boosting this component of credit scores.
If you cancel a card with a $5,000 credit limit, and keep the same average monthly balances on the cards, the credit utilization score increases to 2,000/15,000 or 13 percent, which won’t affect the FICO score much, if any. However, if you carry a monthly balance of say $6,000, cancelling that $5,000 card would create a utilization score of 6,000/15,000, or 40 percent, causing your FICO score to take a hit.
The greater the increase in credit utilization, the greater the drop in credit scores. While an increase in the credit utilization score from 10 percent to 13 percent, for example, will only trigger a minor dip, a jump from e.g. 10 percent to 85 percent in credit utilization could cause a score to plummet over 100 points.
One way to safeguard against spikes in your utilization ratio is to pay down the balances on all your cards. For example, if you have five cards and wish to close one of them, make sure to pay off as much debt as you can on the other four before cancelling the fifth. This way, although your overall available credit decreases, you’ve decreased your debt as well, maintaining a healthy ratio.
2. Keep credit card balances low
For people unable to pay down their credit card debt, closing a credit card without affecting the utilization ratio can be much more difficult. However, there are a few things you can do to minimize the impact. Firstly, shifting monthly expenses to debit cards or prepaid cards can help minimize the effect on the credit utilization ratio. Why? Because the total you’ve charged for the month counts towards your credit utilization ratio, even for cards that you pay off in full each month. By shifting spending to debit cards, you can avoid having the charges counted as part of the credit utilization score.
Secondly, if you’re looking to cancel a card because it introduced an annual fee or changed terms in ways you’re unhappy with, consider applying for a new credit card before canceling the old one. The credit line on the new card will help you maintain you overall utilization ratio, even as you get rid of cards with annual fees, or other unattractive terms.
3. Close new credit cards before old
New credit cards don’t hold as much weight as their predecessors do when it comes to bolstering credit scores. A ten-year-old credit card contributes more points to your credit rating than one that just arrived in the mail. Consequently, if you are looking to pare down your credit cards, to minimize the effect on your credit score, get rid of the newer ones first, all other things being equal.
