This one has always bugged me. And the FICO folks don’t seem to see the irony in it (meaning, they have no plans to change it)…
NPR’s Planet Money blogged about this today, and I think it’s worth posting, as I imagine that many are not aware of the ramifications of doing something that would seem like the ‘right thing to do’.
Basically, if you close a credit card account, it hits you negatively in multiple ways. First, it stays on your credit record, even though it’s listed as closed. Second, you reduce your ‘available credit’ (which is obviously the whole point of closing the account), but this negatively affects your ratio of credit to available credit. If you have a second mortgage on your home for $50,000 (remember when you could still get those?), you are using 100% of your available credit on that line. It is looked at as a revolving line of credit, just like a credit card, and really hurts your credit score to have 100% (or even 90% if you’ve paid some of that down) of that line used.
Apparently, you want to have a 30% ratio of credit used to credit available. I currently don’t have any second loans, and am carrying a bit on my credit cards. But since I no longer have any second mortgages, my credit score has shot up. Doesn’t make sense to me, but FICO thinks otherwise. I still have flawless credit, never missed a payment on anything, etc, but from time to time have carried MUCH more debt (both secured and unsecured). Strangely, with less secured debt right now and more unsecured debt, I’m apparently a more viable borrower. Go figure.
And third, it results in putting an end date on the ‘longevity’ of that account, regardless of why you closed the account. You ‘could’ have kept the account open, but you didn’t, so you get dinged for not having greater longevity with that card.
From the Planet Money blog today…
Gail Cunningham of the National Foundation for Credit Counseling has an answer. FICO scores, which banks and other lenders use to consider how risky a borrower you are, weigh five major categories, Cunningham says.
1) Paying your bills on time — 35 percent of your FICO score.
2) Ratio of credit available to credit used — 30 percent.
3) Longevity of credit accounts — 15 percent.
4) Applications for new credit — 10 percent.
5) Using a range of credit, from fixed payments like a house note to open-ended payments like credit cards — 10 percent.
Canceling a credit card would nick your points in the second and third categories. If you close an account, you obviously affect its longevity — bad for that portion.
If you close an account worth $5,000, Cunningham says, that means you have less overall credit available, which would affect the ratio of credit available to credit used.
So yes, closing accounts and applying for new ones threaten your FICO score.
What’s the optimum ratio of credit available to credit used? “I don’t want to see anyone use more than 30 percent of their available credit,” Cunningham says. “That makes you look as though you don’t have any cash and you’re desperate for credit.”
And a note to people like me who have cards but almost never use them: Take those cards out and buy a little something, Cunningham says. Pay them off at the end of the month, but do use them. “New credit is hard to come by these days,” she says. “You want to keep all of your existing lines of credit. All in the world you represent to a credit card company with your unused card is risk — because you could go out tonight and spend it all.”
So, even though it seems incredibly counter-intuitive right now to keep unused credit card accounts open, that might be your best bet (if you’re looking to buy a home, refinance your home, or do anything that involves your FICO score). Unless you have little or no will power when it comes to buying that new flat-screen TV, and then can’t pay your cards off every month… Then that credit score ding might be worth it.
A Credit Card Dilemma [Planet Money – NPR]
Some good info on how your credit cards relate to your credit score [SFHomeBlog]