I've alluded to this topic on several occasions in the past. My previous blog entries are riddled with references to closing credit-card accounts. Today, we tackle the issue head on.
Let's isolate the two important issues that crop up as a result of account closures. One, your utilization ratio will be impacted. Two, eventually your closed account will get deleted from your credit history.
Utilization will be your most immediate concern, since closing an account takes the credit limit out of the FICO equation (assuming there is no balance on the card when it's closed). Longer term, the closed account will ultimately fall from your credit history, which could impact the average age and length of your credit history (FICO takes both into account). (Not all credit cards report as "revolving," by the way. My Nordstrom Visa Signature (link here) card, which doesn't have a preset spending limit, reports as "Open" on my TransUnion and Equifax credit reports. As a result, my balances don't hurt my utilization ratio. For this column's purposes, though, we'll assume that all cards are treated as revolving.)
We'll look at utilization first. When you close an account, the credit limit on that closed account is no longer factored into the FICO equation. As a hypothetical, imagine that we have four credit cards. Credit card A has a credit limit of $10,000. Credit card B has a limit of $5,000. Credit card C has a limit of $5,000. And credit card D has a limit of $10,000. Further, let's imagine that credit card A has a balance of $6,000. Credit card B has a balance of $2,000. Credit card C has a balance of $2,000. Finally, credit card D had no balance. In sum, the total balance for all four cards is $10,000. In all, utilization is 33% ($10,000 used on $30,000 in credit limits).
For whatever reason, you decide to close credit card D. Now, instead of having $30,000 in available credit, you have $20,000. Worse, your utilization ratio, which was already moving toward the high side at 33%, jumps to 50%. Instead of having $10,000 in balances spread among $30,000 in available credit, you now have $10,000 in balances spread among $20,000. Oops. Assuming nothing else changes on your credit report, it's safe to assume that your FICO score will take a hit when the creditor reports the closed account and the new utilization ratio is computed. Given that utilization accounts for 30% of your FICO score, this shouldn't come as a surprise. I typically advise people to get credit-limit increases on the cards that will remain open. That way the person can mitigate the impact that losing $10,000 will have on overall utilization.
And this note: closed accounts with no balances are not included in the FICO utilization calculation (link here), but closed accounts with balances are! The danger in closing an account with a balance is that the card company could (and likely will) report your limit as $0 -- while also reporting the balance. If that happens, it will appear as though your card is completely maxed out.
As for your credit history, the ill-effects of closing credit card D won't be felt for some time. That's because the credit card, and its history, will remain on your credit report for about ten years more (though, alas, I've seen them fall off sooner). Ten years after closing your account, though, your score could take a hit -- albeit a smaller one -- when the card gets deleted from your credit report. (Length of credit history accounts for 15% of your FICO score.) This assumes that the account that falls off lowers the average age of your history or happens to be your oldest account. Indeed, if all of your accounts were ten years old when you closed credit card D, and you added no new accounts afterward, there would be no change in the average age of your accounts. Ditto length of history. They'd all be, on average, 20 years old when that fourth card fell off your credit report (remember that closed accounts age until the day they fall off the credit report). Thus, there would be no change.
The trouble occurs when you close one of your cards and then add new cards later. Under that scenario, it's easy to see why an old, closed account can harm your score when it gets deleted. A simple illustration should serve us well. Let's pretend that you disavowed credit because of a radio broadcast you heard. You took your only credit card, which was ten years old, and closed it -- chopping it into little pieces. You used cash from then on.
Now let's fast forward ten years. You come across an awesome blog called CreditMattersBlog.com. There, you learn that having credit is actually a good thing. That it is an important thing. Excited, you decide to open a new credit card. The two cards, the closed card that is almost 20 years old now (which is contributing so positively to your length of history), and the new one, give you an average age of 10 years. The following day, your oldest card (the closed one) finally falls off your credit report. All you're left with is one card, which is just a day old. Sadly, it now looks as though you're a credit newbie. The average age of your account can't even be computed, since there is nothing to average, and the length of your history now weighs in at a whopping day.
We can play around with all kinds of scenarios, plugging in all kinds of numbers, but there is no way around it. Keeping older accounts open is important. Unless your oldest account is fee ridden (and you can't get the company to waive the fee), I'd find a way to keep the card open. Also, even if your account has blemishes (lates, for example), you're still being helped in the age department. These accounts continue to help the age component of your credit history. Likewise, closing derogatory accounts doesn't make the negative history go away. Only time can do that.
I wish I knew then what I know now. I thought that closing older accounts (that I wasn't using much) made sense. I thought that closing accounts was the right thing to do. Turns out that I couldn't have been more wrong. Instead of having a bunch of accounts that are 20 years old, I now have cards that are closer to 10 years old.
Learn from my mistakes. Close older accounts only when it's absolutely necessary. Otherwise, leave them alone.