When you work diligently to pay off a credit card, nothing is more satisfying than seeing the balance hit $0. It’s a eureka moment – filled with accomplishment and freedom. And your next desire may be to shred the credit card and close the account. But is that the right move?
What you do next really depends on your spending habits – or better put, your ability not to spend.
Closing the credit account could negatively impact your credit score. But keeping it open may tempt you to spend more and fall back into debt. Let’s review both options so that you can make the best decision for you and your finances.
When You Should Close Your Credit Account
The case for closing your credit card comes down to one thing – temptation. If you find it challenging to resist using your credit card, the wise decision will be to close the account.
Yes, closing the card may negatively affect your credit score a bit. However, a slight drop in your score is much better than accumulating more debt you have to repay – especially if it’s debt you cannot repay quickly.
Why You Should Keep Your Credit Account Open
Credit scores can be tricky and often seem backward. To build a good credit score, you need to have credit available to you – and then prove you can manage that credit responsibly.
Made up of five main factors, credit scores encompass:
- Payment History
- Amount Owed
- Length of Credit
- Credit Mix
- New Credit & Inquiries
Closing a credit card can lead to changes in certain areas of your credit report, possibly causing your score to decline. To illustrate how this works, review the following scenarios.
Credit Utilization Ratio
Before approving any loan, one of the first things a lender will do is calculate your credit utilization ratio (CUR). This is a representation of how much you have spent from your available credit. For example, if you have spent $3,000 on a credit card with a limit of $10,000, your CUR will be 30%.
Lenders typically want this ratio to be below 30% as it demonstrates you’re able to manage credit effectively.
So how does closing a credit card affect your CUR? See for yourself.
Assume you have three credit cards with various balances and limits.
| Balance | Credit Limit | |
| Credit Card A | $500 | $5,000 |
| Credit Card B | $1,500 | $2,500 |
| Credit Card C | $500 | $1,000 |
Between the three credit cards, your total balance is $2,500 ($500 + $1,500 + $500). Your total available credit limit is $8,500 ($5,000 + $2,500 + $1,000). In this example, your credit utilization ratio would be 29%, which is good.
But what if you pay off Credit Card A and close the account?
Your total balance will now be $2,000 ($1,500 + $500), with a total credit limit of $3,500 ($2,500 + $1,000). As a result, your CUR will now jump significantly to 57%! Remember, lenders like to see this ratio below 30%.
Length of Credit
Another component of your credit score is the average length of your credit accounts. Unfortunately, the best way to improve this section is with age. However, closing a credit card can also impact this area – here’s how.
The length of your credit accounts makes up about 15% of your score. This is a mix between your oldest and newest accounts – typically averaged together. If the card you close is one of your oldest credit accounts, it may cause the average age of your credit accounts to decrease. As a result, you will likely see a drop in your credit score.
Credit Mix
Your credit score comprises a mix of credit accounts, such as credit cards, auto loans, student loans, and home loans. Maintaining a variety of credit types helps to improve your credit score. It also shows lenders you are experienced and capable of managing different kinds of debt.
If the credit card you are considering closing is your only credit card, it can affect your overall credit mix – possibly leading to a decline in your score.
Takeaway
Closing a credit card once your balance is paid in full is a great strategy if it’s challenging for you to avoid using the card. However, if you can manage the card and avoid the temptation of using it, keeping the card active is wise and will help build your credit score.
To keep your credit card active, you do need to use it. One of the best ways to accomplish this is by using the credit card to fill up your gas tank once a month. Immediately repay the balance and avoid using the card again – unless for financial emergencies.
We’re Here to Help!
Learning to manage credit and build your score takes time, patience, and an understanding of how credit scores work. Our team is here to answer all your questions and help you determine what financial decisions are right for you.
Please stop by any of our convenient branch locations or call 800-782-4899 to learn how we can help you.
Each individual’s financial situation is unique and readers are encouraged to contact the Credit Union when seeking financial advice on the products and services discussed. This article is for educational purposes only; the authors assume no legal responsibility for the completeness or accuracy of the contents.