If you have not used one of your credit cards for quite some time, the thought of closing it must have crossed your mind. However, when it comes to personal finance, the seemingly practical option may not always be the right one. Cancelling a credit card may hurt your credit score; this is why a number of experts suggest that you leave unused credit cards open. Let us understand how an unused credit card impacts your credit profile.
Your credit score is made up of five things- new credit, outstanding amount, credit mix, credit utilization and the length of your credit history. Your unused credit card directly impacts the last two factors- credit utilization and the length of credit history.
Credit Utilization- This is the ratio of your total available credit to what you are currently using. This includes the debt-to-credit ratio across all your loan accounts along with the individual credit utilization on different credit cards. Financial experts advise users to keep their credit utilization ratio below 30 percent at all times. Unused credit cards help you in maintaining a lower credit utilization ratio.
Credit History- Your credit history is not only determined by the oldest loan or credit card account but the credit bureaus also consider your newest account and the average age of your entire loan accounts combined. A long credit history is considered better as the lenders would be more willing to lend to a person who knows the rules of the market than to someone who has recently stepped into the debt arena.
How closing a credit card impacts your credit score?
As discussed above, unused credit cards have a direct impact on credit utilization ratio and the length of credit history. If you have owned a credit card for quite some time, say two to three years, closing it may not be a wise decision. However, if you have had the card for just a few months, closing it will not have a significant impact on your credit score.
Secondly, an unused credit card keeps a considerable credit limit locked-in, improving the credit utilization ratio which, in turn, improves your credit score. Let us understand this with the help of an example. Rahul has three credit cards with the following limits-
- Credit Card 1- ₹ 1,00,000
- Credit Card 2- ₹ 2,50,000
- Credit Card 3- ₹ 80,000
He is thinking of closing Credit Card 1 as he seldom uses it but has to pay a hefty annual fee. The total debts with Rahul currently amount to ₹ 1,10,000.
|Total Credit Limit||Total Debt||Credit Utilization Ratio|
|Before closing Credit Card 1||₹ 4,30,000||₹ 1,10,000||25.58%|
|After closing Credit Card 1||₹ 3,30,000||₹ 1,10,000||33.33%|
So, closing credit card 1 will make Rahul’s credit utilization ratio shoot up above the reasonable limit of 30% which might result in a decline in his credit score.
When is it a good idea to close your unused credit cards?
Though you should not close your credit card, there are a few situations under which it might make more sense to discontinue a card, such as-
- When the credit card does not offer you any kind of perks.
- When the annual fee on the credit card is too high.
- When you have too many credit card accounts.
If your credit card poses a combination of the first two challenges- it attracts huge annual fee but does not provide benefits that suit your needs- then it may be a good idea to go ahead with credit card discontinuation. Also, you should not have too many loan accounts open at the same time as lenders find such people credit hungry.
Surprisingly, sometimes closing a credit card can also result in an increase in your credit score. This may happen when you have several cards from the same bank and you request them to close a card and transfer its limit to another card. In this case, the credit utilization ratio on one card will come down, thus improving your credit score. Another great way to achieve this is by closing a credit card held for a short duration. This way you can improve the average age of your accounts.
The Bottom Line
Closing a credit card is not recommended but when done strategically it may not come as a regret. It makes sense only when you are required to pay hefty annual fee without getting any benefits whatsoever. Do not just stop using a credit card completely. Rather you should try to understand the rewards and benefits on these cards so that the same can be maximized.
Before closing a credit card account, you must take a closer look at its pros and cons, the types of benefits that it offers and how much harm could be done to your credit score if you close it. The decision will vary from card to card, so you should invest some time into it.