This week’s reader question is one I’ve received many times, which raises the likelihood you’ve wondered about it as well. Here it is, in an edited version:
I got a bug to buy a house. Went to a mortgage broker, and one of her first pieces of advice was to land a secured credit card, which I did. Amazingly, I was able to purchase a home. I refinanced my card, things are looking good. I was even able to recently score a non-secured credit card with the same company where I have my secured card. My question is this: Should I cancel the secured card? It has an annual fee and no perks, whereas the new one has no fee and cash-back perks. I’ve read so often to not cancel cards as it adversely affects one’s credit, but it seems silly to have them both. Any advice? Thanks for your time and attention.
The short answer to your question, Elise, is yes, it’s fine to cancel your secured card. There’s no reason to pay a fee for a card you’re no longer using. Only exception? If you’re currently in the hunt for a mortgage or other loan. In that case, it’s best not to cancel existing lines of credit.
Now let’s take a look at the logic behind that answer.
There’s a reason Elise has read that canceling cards can have a negative effect on your credit score. It can. Here’s how:
Higher credit utilization ratio = lower credit score
“Credit utilization ratio” is a $2 term for a 50 cent concept. It just means the amount of credit you’re using compared to how much you have available. For example, if you’ve got a credit card with a $10,000 limit, and your balance is currently $3,000, you’re using 30 percent of your available credit, and your credit utilization ratio is also 30 percent.
The most widely used credit score, the FICO score, penalizes those who use too much of their available credit. Which makes sense. Nobody wants to lend money to someone up to their eyeballs in debt. So keeping your credit utilization ratio low by not using all your available credit is a good idea.
Many financial types will point to 30 percent as the magic number for credit utilization, suggesting you never use more than 30 percent of your available credit. Keep in mind this doesn’t refer only to the closing balance on your monthly statement. Since your credit score can be pulled anytime, the advice would be to never stray above 30 percent. Doing so, they insist, will destroy your credit score.
How credit utilization works
Credit utilization ratios can be computed by credit line or in total. Say you have two cards, each with a $5,000 credit limit. One card has a $2,000 balance, and the other has a zero balance. Computed individually, the card with the $2,000 balance has a 40 percent utilization ratio, and the one with a zero balance has a zero ratio.
Computed in total, you have $10,000 of credit available and $2,000 outstanding, so your overall credit utilization ratio is 20 percent.
Many experts would suggest that, to maximize your credit score, you should shift $1,000 from one card to the other. Then you’d still have an overall ratio of 20 percent, and each card would also have a 20 percent ratio.
Note that by canceling your unused card, your total available credit is $5,000, and you’re using $2,000, giving you a 40 percent ratio, both on that card and in total. This is why many experts recommend keeping accounts open, even if you’re not using them.
Your credit score is based partly on the length of your credit history
Another reason not to close accounts: A longer history is better than a shorter one, so older accounts are better than new ones. This is also logical. After all, you’d rather lend money to someone with decades of experience paying it back on time than to someone who’s only been dealing with credit for a few months. Therefore, the experts will tell you, closing older accounts will lower your credit score.
It doesn’t hurt to leave old credit lines open, as long as you don’t have too many, are not being charged an annual fee and won’t be tempted to overspend. So unless there’s a reason to close an account — like an annual fee — just stop using it. If you’re ever notified that your account will be closed for inactivity, and it’s one you want to keep, make a small purchase, pay it off, then place the card back in plastic purgatory.
Now that you’ve learned all this, ignore it
In light of what we’ve just learned, why am I advising Elise to get rid of an unused card that carries a fee? Because, in my opinion, most so-called experts are putting far too fine a point on this stuff.For example, it’s often written that credit utilization ratios comprise 30 percent of the FICO credit score. This is false. Utilization ratios are only one component of a larger category comprising 30 percent of credit scores called “Amounts Owed.” You can see the other components here.
Next, there’s that magic 30 percent utilization ratio number — the line you should never cross. But FICO never said 30 percent was magic. That’s something put forth by third-party “experts.” As I explained above, it’s only logical that using less of your available credit is a good idea. But it’s not as if your credit score will plunge if your utilization ratio is 31 percent. Just try to keep it as low as possible.
Easiest way to lower your ratio? Ask for a higher credit limit. A couple of years ago, I doubled a credit line on an American Express card to $20,000 via a telephone keypad menu. It took less than 5 minutes and I never spoke to a human.
As for keeping old accounts open to maintain your credit history, what many “experts” apparently don’t know is FICO scores consider both open and closed accounts, and closed accounts can remain on a credit history for up to 10 years. So closing an old account won’t significantly impact your credit score in the short term.
Finally, and most importantly: Read the popular press, and it’s easy to believe our credit scores must be constantly tweaked and monitored to keep us alive. It’s a credit score, people, not an ICU patient. Unless you’re in the market for a loan, or soon will be, don’t even think of paying some credit card company an annual fee simply because you’re afraid of damage to your credit score. If FICO wants to temporarily lower my score because I won’t pay some bank an annual fee, they can be my guest. Not only will I not suffer, I won’t even notice.
If you’re in the market for a loan, fine: Use every trick in the book to get every point possible. But if you’re not, don’t let the plethora of online pundits convince you to sweat the small stuff. In the decades I’ve been using credit, I’ve never once given even a fleeting thought to my credit utilization ratio, nor have I ever hesitated to close costly lines of credit I no longer had use for. Result? You can see it in the picture at the top of this post. That’s my FICO score: 848 out of a possible 850. Why is it near perfect? Simple. I’ve paid my bills on time every time for a long period of time.
Want to close an account to avoid an annual fee? Here’s how to go about it.
Step 1: Pay it off
While you can close an account to new charges while it still has a balance, to completely close it you should pay it off. So if it’s time to say goodbye, it’s time to zero that balance.
Got any automatic payments hitting the card? Move them.
Once the balance is zero, don’t use the card. Wait a week or two, then check your account online and make sure no charges show up.
Step 2: Break the news — twice
Balance paid? It’s breakup time.
Call the customer service number on the back of your card or on your monthly statement. When you get a customer service rep, confirm that you have a zero balance. Then tell the rep you’re canceling your account.
While you’re on the phone, ask the rep for a name and address where you can send a letter to make it official. When you hang up, write a short letter to that name and address. It doesn’t have to be fancy. Just include your name, address and account number. Say you’re canceling your account and want your credit history to reflect you requested the account be closed.
Use certified mail and request a return receipt so you can prove the company received your letter.
Step 3: Follow up
Let a full 30 days go by, then go to AnnualCreditReport.com and pull a copy of one of your credit reports. The account should show “closed by customer,” not “closed by creditor.”
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I founded Money Talks News in 1991. I’ve earned a CPA (currently inactive), and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.
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