When it comes to managing debts, the logical approach is to close all the accounts that you're no longer using. We stop using cable television, downgrade our cell phones, drive used cars and find ways to save money in our daily lives. With credit cards, it may make sense to close the account, thereby avoiding the temptation to use the card. With how a credit score is calculated, closing that credit card account may end up hurting you down the road more than it would help you.
Credit scores look at how much open credit you have open, versus how much debt you're carrying. They look at how often your payments are on time, and how often you're looking to obtain new credit. All of these are calculated using a top secret formula to come up with the numbers you see on your credit report. That credit score is used by banks and lenders to determine interest rates and how much credit they are willing to lend you (http://www.bankrate.com/finance/credit-cards/why-closing-an-account-hurts-score.aspx).
For example, if you're trying to buy a home, you're going to need 20 percent down payment following the recession in 2008. Most borrowers would finance the remaining 80 percent. The average mortgage in America is a 30 year mortgage, meaning that the interest accumulates on the 80 percent that remains unpaid during that time period. Even a quarter of a percent higher interest can translate to thousands of extra dollars paid during the life of the mortgage.
Closing that credit card account will show a drop in assets, or what the credit bureaus call "income". This drop appears to make the outstanding portion of debt a higher percentage of your income. If that credit card carries a balance when you close it, you're losing the credit limit from your card. Let's look at this as a math example to help clarify.
Let's say you have one credit card with a $5,000 credit limit and no other outstanding debt. Let's say the card has a balance of $2,000. You have $2,000 in debt and $5,000 in income, for a ration of 2:5 debt to income. This is considered a healthy ratio for a borrower.
Now, let's say that you close that $5,000 credit limit, but the card still maintains a $2,000 balance. That same equation now looks like this: $2,000 in debt with $0 in income. That becomes an infinite ratio, which a lender would avoid at all costs. This has now hurt your credit score, so a lender will charge a higher interest rate for that home loan mentioned earlier.
Instead of closing the credit card, pay off the balance prior to closing. Some people will keep cards open that they use once a month for emergencies. They will make one purchase of a few dollars on the card, then pay it off when the bill comes. This avoids inactivity fees and keeps the credit limit available on their credit report. They use this tactic to maintain a high credit score, as their income appears higher to the credit bureau with little to no outstanding debt.
Before you close that credit card, think about your future goals and what you really want financially. If you are the type that knows they can't hold a card without using it, destroy the card and pay off the balance. Don't close a credit card account until after you've paid the balance off. This simple step can help keep up to 60 points on your credit score. It's your credit score, manage it wisely, or you may pay for it later.
Shannon Webster - I have over a decade of experience working with government and financial companies. I enjoy politics, sociology, technology and ...
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