Understanding credit scoring/reporting is one of the pieces of knowledge that you’ll pick up when travel hacking with credit cards. I am constantly checking my credit score and considering the effect that new credit cards and my utilization will have on my score.
With that being said, credit scores are one of the things that is hardest to anticipate. You can estimate how much of an effect a new credit card might have on your score, but you never know for sure until it happens. For instance, I know that opening a new account will result in a inquiry (hard pull) and will lower my average age of accounts (AAoA). At the same time, it will increase my overall credit limit therefore decreasing my utilization rate. There are so many different factors that make up your credit score. Therefore, it is impossible to say that applying for this credit card will decrease your score by 15 points. Who knows your score may actually increase with an increased credit limit thus lowering utilization. What I’m trying to get at is that there are no concrete answers when it comes to credit scores.
However, we do know the credit score factors that go into a credit score and thus can estimate the effects of certain actions. One of these actions that I decided to do further research on is the effect of closing a credit card account. It appears the general consensus is that closing a credit card is bad for your credit score. This has some truth, but I don’t think it paints the full picture.
First off, closing a credit card account affects two credit score factors: Utilization Rate, Average Age of Accounts, and maybe Credit Mix. It does not affect inquires (10% factor). Your hard inquiry for the credit card will stay on your report for 2 years. It also does not affect payment history (35% factor).
Credit Mix (10% factor)
This is basically the idea that companies like to see that you can handle a variety of different types of debt. For instance, there’s auto loans, home mortgages, credit cards, student loans, and more. All of these are different and banks want to see that you can handle any type of debt. Now this doesn’t mean you should go and acquire a every type of debt out there, but it does mean you should maintain a balance. Say for instance, you only have two credit cards and several loans. Closing one of those credit cards may have more of an impact on your credit mix than if you had five credit cards. Overall, this is only 10% of your credit score so closing an account will only have a small effect especially if you have other credit cards.
Utilization Rate (30% factor)
This is the big one. This is the reason you do not want to close credit card accounts. When you close an account, it may increase your overall utilization rate (unless of course you make payments so that your utilization rate is <1%).
Here is a great video which demonstrates how closing a credit card affects utilization: Cancelling a Credit Card.
If you are carrying balances or have high utilization, closing a credit card account will only make this worse. At the same time, closing a credit card account with a lower credit line will have less of an effect on utilization.
Pro Tip: Keep utilization below <1% by paying your credit cards off before the banks report your balance to the credit bureaus. For instance, Chase reports your balance when your credit card statement closes. Therefore, if you pay down your balance to zero, you will have a credit utilization of 0% on that card.
Average Age of Accounts (15%)
Did you know that closed credit cards actually stay on your credit report for ten years? Accounts with negative marks are removed after seven years. This means that even after you close a credit card account it continues to factor into your average age of accounts (AAoA)
There was a great discussion about this topic on reddit: Closing Accounts and AAoA Discussion and Math.
If your credit card does not have an annual fee, there is no point in cancelling it. These no annual fee credit cards help to keep your average age of accounts. I always look to see if a credit card has an option to downgrade to a no annual fee version so that I can keep that account open.
So where does that leave us? Essentially, closing an account will have an immediate effect based on the size of the credit line and your utilization ratios. However, it won’t have an effect on your average age of accounts until ten years down the line. As long as you aren’t cancelling your oldest card, this should have a minimum effect on your credit score as a whole. Before applying for a credit card, you should definitely consider whether or not you plan on keeping that card long term or whether you will be cancelling it when the annual fee comes around. Don’t forget you can also get retention offers on cards, which may allow you to keep the card open longer without any additional costs. For me personally, closing a credit card account rarely has an immediate effect on my credit score since I have several credit lines and keep my utilization low. You can read more about my experience with closing my first credit card here. The lesson learned here is that the main effects on your credit score happen when you first apply not when you cancel a card.