Laura answers a listener's question about whether canceling unused credit cards could help or hurt her upcoming home purchase.
Laura answers a listener's question about whether canceling unused credit cards could help or hurt her upcoming home purchase.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Laura, who says:
"I've finally paid off several credit cards that I probably won't use anymore. I want to simplify my finances, but I’m unsure what to do with them. I'm trying to build my credit before buying a new home later this year, and I've heard conflicting advice. If I cancel my unused cards, would it make me look better to potential lenders because I have fewer credit accounts, or would it hurt me?"
Thanks so much for your question, Laura! Wisely managing credit cards is essential to improve your credit, especially when you have a large purchase on the horizon. This post will review what to consider before canceling credit cards and how to do it strategically if it's the right money move for you.
LISTEN ALSO: 6 ways using credit cards can build excellent credit
The benefits of good credit scores
Building and maintaining good credit is essential for a healthy financial life. It allows you to get competitive interest rates and terms on credit accounts like credit cards, mortgages, and other loans. That could save a massive amount of interest over time.
For example, paying 1% less for a 30-year, fixed-rate mortgage could save you over $100,000 in interest, depending on the total amount borrowed and how long you own the home. While your credit isn't the only factor in the rate you pay for a mortgage or car loan, it's a significant one.
However, even if you never borrow money to finance a home or car, or you choose not to use credit cards, having good credit improves your finances and saves money in other ways, including:
To build credit, you must have active credit accounts in your name and use them responsibly over time. Your transaction data on most credit accounts gets reported to at least one of the three nationwide credit bureaus: Equifax, Experian, and TransUnion.
Then, the information in your credit files gets used by lenders and merchants using various credit scoring models to calculate your scores.
If you don't have any or much data in your credit files, having a "thin" report can hurt you. In fact, having no credit is the same as having bad credit because it doesn't give a creditor enough information to know if you're financially responsible.
Therefore, if you don't have any or enough credit data, you could get denied a loan, credit card, benefit, rental, or pay more interest to borrow money than is necessary.
RELATED: How to pay off credit card debt faster
The downsides of canceling credit cards
Now that you understand how credit helps or hurts your financial life let's return to Laura's question about keeping or canceling her unused credit cards.
One of the most significant factors in your credit scores is how much debt you owe. Laura mentioned recently paying off several credit cards, which is terrific for her credit scores.
Another key factor is a formula called a credit utilization ratio. It compares your debt on revolving accounts, such as credit cards, retail cards, and other lines of credit, to your available credit limits on those accounts. The lower your utilization rate, the higher your scores will be.
Let's say you have two credit cards with credit limits of $1,000 each. If you owe $500 on one card and $0 on the other, your utilization math would be $500 divided by $2,000, or 25%, which is a good ratio. Aim to keep your credit utilization below 20% to 25%.
When your credit utilization increases, you appear riskier, and your credit scores decrease. The idea is that if you can't pay down your balances, you must be spending too much and may even be close to defaulting on your debts.
Getting back to my example, consider what happens if you cancel the card with a $0 balance and a $1,000 credit limit. Once you close it, your utilization ratio drops significantly because your available credit limit gets cut from $2,000 to $1,000.
Your revised utilization ratio is $500 divided by $1,000, or 50%. Even though you have the same amount of debt, your utilization ratio skyrocketed from 25% to 50% because you canceled a card. Like it or not, closing the unused card makes you appear less credit-worthy, and your credit scores plummet.
So, canceling a credit card hurts your credit because it instantly lowers your available credit limit, spiking your utilization ratio. Closing a card is most detrimental to your finances when you're like Laura and plan to finance something expensive, such as a home or car, soon. Jeopardizing your credit could ruin your ability to get a competitive, low-rate loan and cause you to overpay interest for decades.
Many people mistakenly believe that closing a credit card improves their credit, which could be the conflicting advice that Laura mentioned. However, the opposite is true because canceling credit accounts can instantly damage your credit.
But that doesn't mean closing a card is never a good idea. Next, I'll discuss what to consider before canceling a credit card and tips to do it strategically.
RELATED: Tips to minimize credit card damage after a late payment
5 questions to ask before canceling a credit card
While avoiding some negative credit consequences when you close a credit card is impossible, there still may be good reasons to do it. For instance, I don't recommend you have credit accounts that tempt you to overspend or make impulse purchases. Taking a temporary hit to your credit might be well worth it to prevent more significant problems in your financial life.
Before closing a card, consider your answers to the following five questions:
1. Will I need new credit soon?
As I mentioned, if you're planning to buy a home or finance a vehicle or other big purchase soon, how you manage your credit and credit cards is especially important. If you need to take out a big loan within the next 6 to 12 months, I don't recommend closing a credit card.
When your utilization ratio increases and your credit scores decrease, you may not have enough time to recover. You could be turned down for credit or offered an unnecessarily high interest rate.
2. What is my card’s credit limit?
The lower a card's available credit limit, the less canceling it could negatively affect your credit. For instance, if it's less than $1,000, it would cause less damage than closing a card with a $10,000 limit.
If you want to cancel a card and open a new one that you like more, that's a good strategy to offset the hit to your credit utilization. Ensure the new credit limit equals or exceeds the card you want to close.
3. How long have I owned the card?
In addition to making payments on time and keeping a low credit utilization ratio, the time you've had credit accounts in your name is an important credit scoring factor. A long, rich credit file boosts your scores and makes you appear less risky to potential creditors. That's one reason why it takes time for young people to build good credit.
Credit accounts remain in your credit files for ten years--unless they contain negative information, such as late payments. Any credit accounts with bad marks only stay on your credit history for seven years. So, never cancel a paid-off credit card with negative information, such as late payments or a settlement, thinking it will vanish from your credit reports.
Once a credit card's 10- or 7-year period expires, a closed or paid-off account automatically falls off your credit reports. That causes your average length of credit history to decrease. In other words, keeping a card you've owned for many years is better, especially if it has a positive credit history.
A common dilemma is what to do after opening a card you got pressured into at a retail store for a significant discount. If you're loyal to a store and shop there frequently, having its branded card could save you money. While you can't erase a card you opened by mistake from your credit history, if you'd rather not have it, closing it sooner rather than later is better for your credit.
4. How many credit cards do I have?
If you have many cards, closing one with a low credit limit that you haven't owned very long won't significantly hurt your credit. However, if you want to close multiple cards, it's best to space out cancellations by at least six months.
Another credit scoring factor is whether you have a mix of credit types, such as revolving credit and installment loans. Creditors want to know that you can handle different types of credit responsibly.
So, if you only have one credit card, it's best to keep it. You need at least one credit card in good standing for optimal credit.
Another tip is that most credit scoring models calculate your utilization ratio for each of your revolving accounts and collectively on all your accounts. So, it's better to spread out your balances on multiple cards and maintain low utilizations on each than to max out one card.
READ ALSO: How many credit cards should you have for good credit?
5. What benefits do I get from the card?
If you have a rewards card that charges an annual fee, consider if you could be getting more from it, such as cashback, airline miles, or points for merchandise. Sometimes, a card's potential rewards are worth much more than its fee.
However, if you can't afford the annual fee or know that you won't use a rewards card to your advantage, you should close it strategically, using the tips provided here. At the very least, consider applying for a new card you would use and try to get a similar credit limit to avoid damage to your credit.
When you keep a credit card you don't like or use very often, it's best not to ignore it completely. If you don't use it for an extended period, an issuer may decrease your credit limit or inactivate the account. So, consider making small monthly or quarterly purchases to ensure a card stays active. That allows you to continue adding positive information to your credit history.
To sum up, I recommend that Laura keep her credit cards and avoid any money moves that could hurt her credit until after she buys a home. Even then, she may want to keep them if she’s owned them a long time, they have high credit limits, or would add to her mix of credit account types.
Before we go, here's a quick reminder to subscribe to The Money Stack, my Substack newsletter, when you visit LauraDAdams.com. It's filled with money tips, tools, news, challenges, and things I enjoy! You can subscribe for free or become a paid member with access to live educational events like my upcoming Smart Investing Masterclass called Overcome Your Fears & Procrastination and Start Building Wealth.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio-engineers the show. Brannan Goetschius is our director of podcasts, Holly Hutchings is our digital operations specialist, Morgan Christianson is our advertising operations specialist, Davina Tomlin is our marketing and publicity associate, and Nathaniel Hoopes is our marketing contractor.