Should I Cancel My Credit Card To Improve My Credit Score?

Posted by Sidney Chen :: July 14, 2007 @ 6:53 am

Recently, Maneesh Sethi wrote about ways to maintain a good credit score and he suggested that closing unused accounts could help increase your FICO score. Depending on your situation, this can be good advice. We here at Lending Club felt this topic was important enough to warrant an in-depth examination.

Your FICO score is based on a model that uses any of ten different scorecards depending on the profile of the individual. This is the reason that the impact may be different – it depends on which scorecard is used. However, in general, three major factors contribute to understanding this issue:

1) Length of the borrower’s credit history
2) Amount of credit available to the borrower
3) Number of tradelines (or open credit accounts)

Each of these factors is weighed independently, although the length of credit history generally outweighs credit availability, which in turn generally outweighs the number of credit accounts. So, how should you decide whether or not to cancel a credit card? Here are some issues to consider:

Age of Accounts. Is the credit card the oldest one you have?

If so, generally speaking, you should not close the account. Your credit score weights the length of credit history heavily. Over time, people establish a predictive pattern of how they pay their debts. That pattern has been reliable in predicting who will likely pay and who will likely become delinquent. Therefore, someone with 20 years of good credit history will have a higher score than someone with 5 years of similar credit history.

If the credit card you’re considering closing carries a long history of good credit, and you do not have other credit cards with as long a history, it’s probably best to keep the credit card to maintain that credit history. Otherwise, you may not need to keep this credit card. Read on for more…

Credit Utilization. What is the credit limit on the card you are considering closing? What are the balances on your credit cards?

Credit utilization measures your outstanding credit balances against your total available credit. Above a certain point, the higher the credit utilization on your credit cards, the lower your credit scores will be. Closing your largest credit line account without paying down your debt will raise your overall credit utilization and your FICO score will likely decrease.

Number of Accounts. How many credit cards do you have? How many do you need?

Since Fair Isaac Company, the developer of the FICO credit score, does not disclose the details of its scorecards, we don’t know the exact formula it uses to determine the optimum number of credit card accounts. However, we do know that having too many credit card accounts with balances will lower your score, since you may be over-burdened with debt. On the other hand, having too few accounts will also lower your score since there may not be enough information to demonstrate your creditworthiness. Thus, if you have a lot of credit cards with balances, it may help to cancel a couple of the more recently opened ones.

Scenarios
To illustrate how these factors work together, let’s assume the following scenario: Joe Borrower has 5 credit cards, each with a $4,000 credit limit, giving him a total credit of $20,000. Should he close some accounts? Joe should keep the oldest account, whether he uses it or not. Beyond that:

• Say Joe owes a balance of $12,000, spread evenly over the 5 cards. He should consider keeping all of the accounts open. If he closed one, his credit usage would go from 60% ($12,000/$20,000) to 75% (12,000/16,000), which may lower his score.
• If, on the other hand, Joe only owed a balance of $2,000, he might benefit from closing a card. If he canceled one card, his utilization will be 12.5% ($2,000/$16,000), while reducing the number of open tradelines. This may improve his score.

Conclusion
Your individual situation will determine whether canceling a credit card will improve your credit score. Our general advice is to keep your oldest credit card account open, keep your balances low in relation to your available credit limit, and cancel any underused extra credit cards which may tempt you to overspend.