Whenever I tell someone that i’ve recently canceled a credit card, or am planning to do so in the near future the response is almost always something along the lines of; “Thats bad, you should never cancel a credit card.” To someone who is not well versed in how their credit score is calculated, or for those that are not fully aware of the ramifications of a canceled card, thats fine. The reality however, is that if you understand your score, how it is derived, and what exactly will happen when you cancel a card then there is nothing wrong with it. In fact, in some cases, canceling a card will actually increase your credit score. How? Lets dive in. First, if you’ve not read read the post on how your credit score is calculated I would recommend checking that out and them coming back.
As a general refresher just know that two factors in determining your credit score are; credit utilization, and length of credit history. Credit utilization is the amount of credit you’ve got available to you, divided by the amount you owe across all lines of credit. So for instance lets say that you’ve got 3 cards, each has a $10,000 limit and you currently owe $5,000. This means that your total available credit is $30,000 which divided by $5,000 means that you’re at a 6% rate of utilization. Generally speaking, anything less than 9-10% is considered to be pretty good. Now lets say you go and cancel one of your cards, but you still owe that same $5,000. Now your total available credit is $20,000 but you’ve increased your utilization to 20%. This is not a good thing, and will cause your credit score to go down, perhaps considerably, until you’re able to make enough payments such that your utilization falls below 10%.
The second factor mentioned is average age of your accounts. This is the average age of all of your open lines of credit. Lets go back to our initial scenario, 3 lines of credit, $10k limit on each line. Lets say your oldest card is 10 years, next is 5, and the newest is 6 months. The average age of your credit history then is (10*12)+(5*12)+6 = 186 total months / 3 open lines = 62 months / 12 = 5.12 years. 5 years is average, good not great, but certainly not bad. Now lets say that when you canceled the card in the previous scenario you canceled your card that was 10 years old. Uh oh! Your new average across your remaining to accounts is now only 2.75 years! You’ve nearly cut your average credit history in half, and gone from okay, to poor in terms of your average age.
So cancelling a card is bad, right?
Yes and no. In the example above you canceled your oldest line of credit, and in so doing you more than doubled your credit card utilization. Doing either of those two things is bad enough, but doing both can lead to a precipitous drop in your credit score. But you said yes and no, so their must be a way to cancel a card that will not adversely affect your credit, right? The answer of course is yes and it really boils down to knowing and really understanding the current state of your credit score before you go off and cancel a line of credit. The questions you should ask yourself before you pick up the phone and cancel are:
- How will this affect my average age?
- How will this affect my overall utilization?
If in the example above you canceled the card that was only 6 months old then you would’ve actually increased your average age because now the equation becomes 180 total months / 2 open lines / 12 months == 7.5 years. That is a good thing! Of course, you’ve still got the utilization problem, but that can be rectified by paying off that outstanding $5,000 balance. If you canceled your 6 month old card, and pay off say $3,000 of the $5,000 that you owed now you’re back to a 10% utilization and again you will have increased your average age to 7.5 years. In this scenario chances are your score will go up after you cancel the card!
So how often do you cancel credit cards?
There are many cards in my wallet that I do not use, at all. They simply exist in my wallet because they’re much older lines of credit so they help my average age, and they help reduce my overall utilization number. That being said, every 6-12 months I take a look at my wallet from a high level and decide if any one card still deserves a place in my wallet. If the answer is no, then I make plans to cancel the card. I performed this analysis recently and decided that the Discover IT card is no longer a valuable member of my portfolio and have begun to plot the necessary steps towards cancellation. To review those steps include:
- How will this affect my average age – When looking at my free credit report @ CreditKarma.com I noticed that i’ve only had this card for 1 year and 9 months (21 months total), and its actually pulling down my average age. In my particular case, average age is actually the thing that its hurting my score the most (as of this writing I’m right around 3.5 years). So canceling this card will boost that average.
- How will this affect my overall utilization – My Discover IT limit is $5,250 and my current overall utilization is at 4.7%. Once I cancel that card my overall utilization will increase from 4.7% to 5.4. Sure its an increase, but its not a big deal. Moreover, thanks to my recently Sapphire Reserve approval my utilization is set to come way down thanks to that new credit line.
Benefit To Cancelling
As far as the reasons for cancelling or the benefits, I could do a whole post on that but for know just know that:
- Canceling the card means that I could sign up for it again in the future and take advantage of another signup bonus
- Canceling the card means that I have one less card to worry about. This is especially nice when you consider the data breaches and hacks that seem to happen more often now than they ever have.
In the future I plan on doing more articles/podcasts around taking inventory of my wallet, and making these decisions. For now just know that cancelling a card is not inherently bad but you do need to understand the ramifications before you pull the trigger.
If you’re confused, or want my opinion on whether or not you should cancel a card please feel free to reach out! I’d love to help walk you through my inventory process and/or help you decide if canceling a card is the right thing for you.