7/15/2013 4:15 PM ET|
The biggest credit mistake you can make
But if you have to take this drastic step, here are 3 ways to do it without hurting your finances.
Some credit mistakes are obvious. Everybody knows the big one: Failing to pay your bills on time. If you're looking to wreck your credit score, there's no faster way.
Some credit mistakes aren't so obvious. What's worse, the biggest secret credit mistake -- the one most people don't even know they're making -- actually happens when people are trying to turn their credit score around and be more financially responsible.
That mistake is closing credit card accounts. I know this might sound surprising to some, especially those who have labored for years to pay off big credit card balances. It's understandable. You just made the final payment, and it would feel so good to call the customer service department of your credit card company and say (to paraphrase Henny Youngman): "Take my credit card, please!"
You have to resist temptation here. My best advice: Put your hands on your head, and back away from the phone.
The truth of the matter is that, depending on your financial situation, closing credit accounts could be the biggest mistake you never saw coming.
First, the implications could come further down the road, long after you've forgotten about that closed account. The good news is that good credit sticks around longer than bad credit. Delinquencies and bankruptcies will stain your credit history for seven years and 10 years respectively, but a credit card account with zero delinquencies stays on your report for a full 10 years after it is closed -- and your credit score will benefit from that history during that time.
Unfortunately, after 10 years, that closed account will drop off your credit report. And when it does, you'll lose all of the positive history associated with that account. And if your overall length of credit history declines when that account goes away for good, then your score will take a hit. Surprise!
The various aspects of your credit profile are weighted differently. FICO and the major credit bureaus allocate about 15% of your credit score to the age of your credit history. So, it still matters -- but not that much.
Now for more bad news. The second largest component of your credit score (weighted at a hefty 30%) is called the "credit utilization ratio." It's a fancy way of saying, "How much of your available credit do you actually use?" The general rule: The less, the better. Less is defined as around 10%.
Allow me to illustrate this point: Let's say you're an adult in your 20s; you were approved for your first credit card at age 18, got a couple more during the years you inhabited the ivory tower of whatever institution of higher learning you attended and racked up a hefty amount of debt; you then busted your butt to pay it off. Other than that, you have a car loan and you rent your apartment.
If the combined available credit of your three credit card accounts is $15,000 and you are running a $2,000 balance, your utilization ratio is about 13.3%. This doesn't negatively impact your score. Let's say, however, in your continuing effort to protect you from yourself, you opt to close two of them. Your available credit is reduced to $5,000 and running that same $2,000 balance puts your utilization rate at 40%. This would definitely hurt your score and also make it much more difficult to replace that credit in the future.
Now, I'm not saying you should never close a credit card. If you find a lower rate card, or one with better rewards (and the credit limit of the new card is equal to or more than the one you are closing), or you can raise the limits of existing cards to cover the credit limit shortfall it might be worth taking the minor hit to your score caused by reducing the age of your credit history. Just be careful, as a lender may access your credit report and generate a hard inquiry, which can have an additional impact on your score.
If a card is used fraudulently and your bank doesn't cancel the card and issue a replacement, you should definitely close it immediately. If your relationship is breaking up, and you share a joint credit card with your partner, close the account. Otherwise, you will remain responsible for any excesses or late payments by your ex. If you never use a card that charges a high annual fee, closing it might make sense -- but think about it first. There are other examples, but the general rule of thumb is: keep those accounts open.
Even if you have a perfectly valid reason, simply closing a credit card could hurt your credit score. Here are three ways to minimize that damage and speed your credit score's recovery:
1. Close the right card. Avoid closing the card you've had the longest, with the highest credit limit and the lowest interest rate and fees. Store credit cards tend to come with high fees and low credit limits, so consider closing those.
2. Pick the right moment. Closing a card immediately before applying for a loan could cost you in higher interest payments. Don't close it until after the loan is approved.
3. Manage your ratio. First, request a higher credit limit from the cards you have left. (Again, be careful, as this may generate a hard inquiry. You can ask the credit card company rep if this is their practice.) If you are planning to close a credit card account, you should pay down balances on your remaining cards as well, since those balances may drag down your score.
Finally, Dave Ramsey to the contrary notwithstanding, don't fall into the trap of avoiding credit altogether. Credit is an asset. It can help you attain your goals, including buying a home, a car and achieving financial security.
It's a good thing to pay down debt, but once it's gone and you can breathe normally again, if you wish to resist temptation, shred your credit card, put it in a safe deposit box or give it to your mother (and make her swear she won't use it) -- just don't close the account.
More from Credit.com:
VIDEO ON MSN MONEY
I think it has already been said...don't carry a balance. I have multiple credit cards based on different rewards offered by each. I have more credit then I will ever use. The trick is to not EVER carry a balance. They can jack the interest rates as much as they like, I don't pay them - they pay me to use their cards. My reward kickbacks average around 3%.
Credit cards are a racket, but you can beat them at their own game. Spend only what you can pay back each month. I know it is hard in our spend now pay later economy, but it can be done...
Fellow Americans, credit scoring is a HUGE SCAM! Believe it!
Listen, folks, we KNOW that the big banks came up with this racket.
WHY? Because now they can let their highly-paid underwriters go and simply use FICO and other tools to evaluate your creditworthiness. But you also know that if the big banks came up with this brainstorm, it is to THEIR (NOT YOUR) advantage!!
WHAT? Are you really dumb or gullible enough to believe that they did this to save YOU money? If so, I have some oceanfront property in Nebraska that I'd LOVE to sell you! Again, creditscoring is a RACKET to allow Big Banks to inflate your RISK so they can inflate your RATES! NO KIDDING!
Instead of looking at credit cards as licenses to buy lots of stuff quickly, treat them as safety nets during tough times. Don't rack them up beyond more than you can pay off each month, as much as possible.
Everybody should have at least one card with enough credit limit to tide you over in case of a cash crunch situation. For example, if your car unexpectedly breaks down and you need to get it towed and fixed. But don't abuse your credit by buying lots of frivolous things that you could live without or could buy later after saving money towards that purchase.
So you're proposing that we pay the annual fees and service charges for a card we're not using, in perpetuity, just to keep our credit record intact? You work for a credit card company, don't you?
I can't afford to do that.
Some things REQUIRE a credit card. Travelling? Want to hold that hotel? Must have a credit card. You may want to use your debit card to do this but they usually freeze money in your account. And it stays frozen until they've added any "extra" charges / verified that you didn't steal towels or trash the room. Many gas stations even freeze money in your account if you pay at the pump. And those frozen assets can cause legitimate purchases from the debit account to bounce or incur overdraft fees.
Use credit responsibly. Stick to your budget and pay it off before you incur charges.
Credit card companies close your account if you don't use their card enough, it's a no win situation in my opinion.
They upped my credit card limit to $9,500. My balance: $0
Just because you have a credit card, doesn't mean you have to use it. Then again, it's nice to know if my furnace, etc. needs replacing on short notice, I can just pull out the card instead of having $5,000 or whatever cash laying around...and then just pay the balance in full with a few mouse clicks.
Copyright © 2014 Microsoft. All rights reserved.
Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.