My dad always said, “Son, don’t borrow money unless you absolutely have to.” Dad was a depression-era baby and he saw people who financially crashed and burned when the U.S. economic system crashed and burned.
But today, credit is king. According to Debt.org, total U. S. consumer debt is $13.86 trillion, which includes mortgages, auto loans, credit cards and student loans. On average, each household with a credit card carries $8,398 in credit card debt.
Your credit score drives most of your financial life. It determines whether you can borrow money from lending institutions and credit card companies and, if so, what your interest rate will be. Your credit score can determine your insurance rates, whether someone will rent you an apartment, if you’ll have to pay the utility company an upfront deposit and, in some cases, whether you get hired for that new job. No surprise, the higher your score the more willing people are to take a risk on you.
My dad’s generation would have reasoned that the less credit you have the better your credit will be and closing a credit card will improve your credit. So, it seems counter-intuitive that closing a credit card you don’t want or don’t use anymore can actually hurt your credit score. Here’s why.
Lenders consider your capacity, which is the ratio between your total credit card limits and your credit card balances. In other words, how much credit has been extended to you and how much have you used. For example, if your credit card limit is $20,000 and your balance is $10,000 you have capacity of 50% ($20k-$10k/$20k=50%). Gary Campbell, a lending specialist at SunTrust Bank, says lenders prefer you to have capacity of 30 percent or more. Closing a credit card lowers your capacity which in turn damages your credit score.
If you have 2 credit cards, each with a $10,000 limit, you have a combined credit limit of $20,000. One card has a balance of $5,000 and the other has a zero balance for capacity of 75% ($20k-$5k/$20k=75%). If you cancel the zero-balance card your credit limit is now $10,000 and your capacity drops to 50% ($10k-$5k/$10k=50%).
Then, there’s reduction in credit history. Lenders look at how long accounts have been open. Closing credit cards you’ve had for a long time shortens the average age of your accounts, which also negatively impacts your credit score.
But if you decide to hang on to those old cards in order to keep your capacity level up, you run the risk of having the card cancelled by the issuer for non-use. To make sure that doesn’t happen, keep them active by making an occasional purchase and paying it off at the end of the month, or set up a small recurring charge so there’s some activity. It’s the credit game you have to play.