Your credit score is an intangible asset that exhibits your financial credibility. The better your score, the more you can do.
But credit scores also tend to be shrouded in mystery. This leaves many consumers unsure of how to handle situations that might be good for them but also might be bad for their credit scores. It can be extremely difficult to strike the balance between what you want and need financially and how those things will impact your score.
Closing accounts is one of the biggest questions people have in this sense. It seems unnecessary and even financially harmful to leave unused accounts open. But closing accounts could cause problems as well. Here's how you can decide if cleaning the clutter in your financial accounts will be helpful or harmful for your particular situation.
What Is a Credit Score
Just about everyone knows they have a credit score, but do you know what this really is? A credit score is a score assigned to you by the various credit reporting bureaus to determine the level of risk in lending to you.
The higher your score, the more likely you'll get approved for new credit. Plus, the lower your interest rates will be. (Since interest rates are not just a way to earn profit, but also a form of protection in case of default. If you default, at least the lender was able to earn some more money back in the process to mitigate against what they lose if you default.) Here are some examples of differences you'll see in interest rates based on different credit scores:
How Your Credit Score Can Affect Your Future Mortgage Rate
|Credit Score Range||30-Year Fixed Rate Mortgage||5-year fixed rate mortgage||7/1 ARM|
How Your Credit Score Can Affect Your Next Car Loan
|Credit Score Range||60-Month new Car Loan||40-Month Used Car Loan|
How Your Credit Score Can Affect Your Next General Loan
|Credit Score Range||HELOC||Home Equity Loan|
Building and maintaining a strong credit score can set you up for a lifetime of financial opportunity. Now let's talk about how it's calculated.
How Your Credit Score is Calculated
No one knows exactly how a credit score is calculated. Not only are the formulas varied, there are many of them. To start with, there are three credit reporting bureaus. Each of these bureaus (Experian, Transunion, Equifax) have their own formula. Then, each lender uses their own algorithm based on their lending product. So, when it comes down to it, everyone has upwards of 30+ credit scores.
While no one knows exactly how a credit score is calculated, the five main factors that go into the score are widely known. Those factors are your payment history, your debt level, your length of credit history, credit inquiries, and mix of credit.
FICO Credit Score Factors and Their Percentages
|FICO credit score factors||Percentage weight on credit score:||What it means:|
|Payment history||35%||Your track record when it comes to making (at least) the minimum payment by the due date.|
|Amounts owed||30%||How much of your borrowing potential is actually being used. Determined by dividing total debt by total credit limits.|
|Length of credit history||15%||The average age of your active credit lines. Longer histories tend to show responsibility with credit.|
|Credit mix||10%||The different types of active credit lines that you handle (e.g., mortgage, credit cards, students loans, etc.)|
|New credit||10%||The new lines of credit that you've requested. New credit applications tend to hurt you score temporarily. Learn more about FICO credit score|
Of the five main factors, we'll focus on length of credit history and credit utilization for now. Length of credit history is just as it sounds: how long your accounts have been open. Credit utilization is the amount of debt you have in comparison to how much credit is available to you. Both of these factors will be impacted by closing accounts - but not all accounts. Let's dive deeper.
How Closing Accounts Impacts Your Credit Score
Closing a savings account does no harm whatsoever to your credit score. There is no credit line tied to this type of account so it doesn’t show up on your credit report. Because credit scores are calculated with the data on credit reports, what isn’t reported isn’t included in the calculation.
Instead, you could find your personal banking report at a website such as ChexSystems.
Like a savings account, closing a checking account does nothing to your credit score. Despite being able to swipe as “credit” with a debit card, a credit line does not exist on the checking account.
While closing a checking account won’t directly hurt your credit score, you should still be careful:
Having a negative account balance
When you have a negative account balance for an extended period of time, possibly because of outstanding overdrafts, the bank could send your account to a debt collection agency. Your checking account is closed as a result.
In this case, your credit scores will experience a significant decrease.
Having an overdraft line of credit
Banks that provide an overdraft line of credit may pull your credit report if you opt to have this service. Basically, it is a small credit line to cover any transactions that will result in a negative balance in your checking account.
And, like with any inquiry for a loan or credit line, you’ll see your credit scores will drop slightly.
This may be the only condition that would have some effect on your credit scores when you close your checking account. Since you will lose this line of credit, it can increase your debt utilization ratio (total debt divided by total combined credit limits), which temporarily hurts your credit scores.
More likely than not, you shouldn’t worry too much about the impact of closing your checking account on your credit profile.
Credit card accounts are included in your credit reports. Therefore, credit cards play a part in the total calculation of your credit score. This is partly because of the length of history factor and partly because of credit utilization.
When you close a credit card you're no longer using, your history automatically decreases. This can have a negative impact on your score. A long credit history is favorable because it exhibits long-term responsibility.
According to FICO, the age of the oldest account, the age of the newest account, and the average age of accounts are included in the credit score calculations. A closed account’s age and payment history will remain on the credit report for up to a decade but will no longer contribute to the increase in average age of credit accounts as time goes on. If your closed account ages out, you no longer benefit from the good behavior you exhibited on that account.
Also, as discussed above, it's important to consider your credit utilization. This representation of how much of your credit you're using shows up as a percentage. And lenders want to see a percentage of 30% or less. If it's higher than that, lenders could consider you a risk, thinking you might be getting close to maxing out on your credit.
So how does closing a credit card affect your credit utilization? Closing a credit card decreases the amount of credit available to you, which will increase your credit utilization ratio. Therefore, if you're carrying other debt, closing a credit card can hurt your score. If you have no debt, your debt utilization ratio would remain at zero and have a minimal effect on your credit score.
Keep the Account Open or Close It? How to Decide
In the question of what you should and shouldn't do because of your credit score, it's important to understand that your credit score isn't everything. We all naturally want to have the highest score possible. But if we chase that high score to the detriment to our finances, then we're defeating the purpose of a credit score.
That's why there's no clear-cut answer on what you should and shouldn't do. These are simply factors to consider. If you want to close a credit card because you're too afraid you'll use it impulsively and fall into debt, then you should close it. Keeping it open to improve your credit score won't be worth it if you end up in high-interest debt.
This is just one example of how you should view these issues. Consider the reasons behind your desired actions and then consider the effects on your finances. You want to make a decision that will put you in the best financial position possible, even if it's not the best thing for your credit score.
Don't forget to also consider creative workarounds. Let's go back to the credit card example. If your main fear is using the card impulsively, you could do things to prevent that so you can keep it open. Some people have gone so far as to freeze their card in a block of ice so that melting it to use the card would take hours and thus remove impromptu purchases. Others may find it just as effective to cut the card up and remove it from all their online accounts.
The point is, you can take precautions that will help you achieve multiple goals at the same time, such as refraining from using a credit card while also keeping it open. If your worry is keeping accounts open might subject them to fraud, just be sure to check your accounts and credit report regularly so you can report suspicious findings as they happen. This is just another workaround you can try.
At the end of the day, it's really easy to give out financial advice. It's also easy to know the right thing to do on paper. But if you're not tuned into your financial wants and needs as well as your strengths and weaknesses, then none of this advice will help you. Get to know the things that will work best for you where you are today, then re-evaluate each year. Over time, it will get a lot easier to know what you should and shouldn't do.