After the hard work of paying off a credit card's balance is done, many people close the account to avoid temptation. However, as people learn more about their credit and just how important their FICO scores are, they're beginning to second-guess traditional wisdom. The short answer is: Yes, closing a credit card can hurt your credit.
FICO Explained
Your FICO score (named for Fair Isaac Corp.) is a number designed to measure risk, specifically the risk lenders take in offering you loans. To come up with your score, each of the three credit reporting bureaus--Equifax, Experian, and TransUnion--uses slightly different formulas and analyzes different information. There are five factors that go into every score: payment history, balances, credit history, new accounts, and types of credit. Your balances and credit history are why closing a card can hurt you.
Debt Ratio
The second-largest factor in your credit score is your ratio of debt compared to your available credit. This accounts for 30 percent of your score. Say you have two credit cards, both with $5,000 limits. Say you have a $3,000 balance on the first card, and you decide to close the second. You used to have a ratio of 3/10, but after closing the second card, you now have a ratio of 3/5. You're now much closer to your overall credit limit, which will make your score drop.
Credit History
The other reason that closing a credit card could hurt your credit is the history that is tied up in the card. Credit history accounts for 15 percent of your score, and when you close an account, that history is lost. A credit card that has been open and maintained for 10 years is a signal to lenders that you're trustworthy and know how to handle credit. Unless the credit card has unreasonable terms, it's best to keep it open and its history intact.
Avoid Closing
A major reason that people close credit cards is the temptation to spend. If the card has a low limit and has been open less than a year, closing might not affect your credit score too much. But if you have a good limit, a long history, and no desire to use the card in the foreseeable future, freeze the card in a block of ice. You won't be able to use it or abuse it. Should you need the card in the future, just set the ice block in the sink and wait.
Choosing the Right Card
Many people choose to never open a credit card, having heard too many horror stories of crippling debt. However, a large portion of your credit score is made up of credit cards. You'd have a score even if you didn't have cards, but lenders prefer customers with a history of managing credit responsibly. Choose a card with a low interest rate and no annual fee, even if the line of credit isn't that big. Over time, you'll prove your worth and will be offered larger lines of credit. Personal-finance guru Suze Orman recommends applying for credit cards through credit unions, as they tend to have better terms.
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