What Happens to Your Credit Score When You Cancel a Credit Card?

Canceling your credit card can impact your credit score in a positive or negative way. Many financial advisers warn against canceling credit cards as it can lower the credit score by pulling up the credit card utilization rate. Although the FICO algorithm used to calculate the credit score is not fully disclosed, the general factors and their weighted effects on the final score are publicly known ever since. Card utilization rate is believed to be one of the sub-factors that can significantly lower the final credit score if it exceeds 30 or 35 percent. You might want to see additional ways to repair your credit at http://www.realestateproarticles.com/credit-repair.php . Generally, credit card companies prefer to extend more credit to borrowers with a card utilization rate not exceeding this limit.

What is card utilization rate? Basic understanding of credit jargon can mean a lot for your financial well-being. When lenders talk about card utilization rate or ratio, they are referring to your card balance as a percentage of all the credit limit made available to you by all your card issuers. To illustrate, let us say you have a Visa, Masters and Discovery cards, each with a credit limit of $10,000. Thus , your total credit line is $30,000, the product of $10,000 times 3. If you only use Masters and your balance in that card is $5000, your utilization rate is 16.7 percent, ($5000 / $30,000 x 100). In this example, the Visa and Discovery cards have a zero balance. Credit card balance refers to the amount you owe your credit card issuer. A zero credit card balance means you have no outstanding debt, while a positive balance means you have used your credit line and therefore owe money to your card issuer.

Continuing with the above example, let's further assume that you drop the two cards with a zero balance. This will lower your credit limit from $30,000 to $10,0000. Since your credit card utilization rate is the ratio of your credit card balance to total credit limit, canceling the two cards will increase your card utilization ratio from 16.7 percent to 50 percent ($5,000 / $10,000 x 100).

The same effect on card utilization rate can be expected when the Visa and Discovery cards have a positive balance. Let's say that the two cards have a balance of $1000 each. This time, your cumulative balance is therefore $7000 or the sum of all the balances in three cards. Divide this amount to $30,000 credit limit, and you'll get a utilization rate of 23 percent. If you will cancel the Visa and Discovery cards, your card utilization rate would jump to 70 percent ($7000/$10,000 x 100).

In both examples, the card utilization rate drops when two cards are canceled. The rate of decline is greater when the cards that are canceled have an unpaid balance. Many financial experts believe that the FICO algorithm does not weigh the nature of card cancellation when recomputing the new card utilization rate. Some find it counter-intuitive that the FICO system will discourage Americans from limiting their debt via credit card cancellation. However, a drop in credit card limit cannot be attributed to voluntary cancellation alone. Some borrowers may get lower credit limit because one or two of their credit card issuers lower the credit line or suspend the account due to non-payment.

Does it mean that Americans should never cancel the cards that they do not need just to protect their credit scores? Absolutely not. If canceling credit cards can help you settle more debt or reduce outstanding loans faster, then your balance and card utilization rate will drop in no time. Your credit score may drop immediately after you cancel your card, but it may be temporary only. How fast you can see the positive effect will depend on how well your debts improve after you cancel your cards. For people who cannot restrain their wasteful shopping habits, canceling some credit cards can significantly lower their balances and leave them with more money to pay off their debt. The result will be lower card utilization rate and thus better credit score.