Sometimes, in order to get our finances under control, it helps to take away some of our ability to access credit. Other times we may close an account as part of the debt negotiation process.
Many people are concerned about the affects that closing an account in either of the above cases can have on their credit score.
It's true, closing credit accounts CAN cause your credit score to drop.
When you are working to improve your CREDIT SCORE, closing accounts is generally the last thing you want to do.
But what about those other scenarios? What if you really do NEED to close a credit account?
What affect will it have on your credit?
(And perhaps the most important question…)
What can you do about it?
In order to know what can be done about the credit score drop that occurs as a result of closed accounts, we need to understand what causes the drop.
Some people mistakenly think that closing a credit account causes the to lose their credit history associated with that account.
This isn't the case, though.
Your credit history stays, even when the account is closed. The closed status will just be reflected on your credit report. (The history doesn't go away, otherwise getting rid of negative credit history would just be a matter of closing your accounts!)
So what causes the credit score "ding", then?
It really boils down to one thing:
YOUR DEBT TO CREDIT RATIO.
According to www.myfico.com, around 30% of your credit score is made up of "amounts owed". More specifically, it is made up of the amounts owed on debts compared to the amount of available credit. This is called your "debt to credit ratio", or "credit utilization".
The main cause of the score drop associated with closing a credit account is what the closing of the account does to your debt to credit ratio.
For example, let's say you have two credit cards. One has a $10,000 limit and the other has a $5,000 limit.
You have a $4,000 balance on the $5,000 card, and a $2,000 balance on the $10,000 card. So you're using $6,000 (total) of your $15,000 total available credit.
What happens if you close the account with the $10,000 limit?
Your credit limit on that card goes away. (There is no longer "available credit" if the account is closed.)
The credit limit may be replaced with the amount you owe.
So instead of using $6,000 out of your $15,000 available credit, it suddenly looks like you're using $6,000 out of only $7,000 in available credit.
Your debt to credit ratio just went through the roof!
Since 30% of your credit score is credit utilization, this can have a rather drastic effect on your score.
Now for the most important question:
What can you do about it?
If you know you are going to close a credit account for one reason or another, you can take steps to minimize the damage by opening up another credit line that reports to the bureaus, such as with another credit card, a sub-prime merchandise card, or department store line of credit. Any card that reports a credit limit will do, because what you need is something that will offset the change in your debt to credit ratio.
If you're closing accounts in an effort to get your spending under control, you can try to minimize the effect by closing only the accounts that already have a high debt to credit ratio and/or the accounts with the lower credit limits.
Another approach is to ask for a credit line increase on one card before closing another.
Note that the reverse of this the above scoring affect can also be used to your advantage.
Let's say that your debt to credit ratio is currently high and hurting your credit score. If you have an old credit account that can be re-opened and added to your total available credit, this could give your score a boost by improving your credit utilization virtually overnight, and with little or no cost to you.
As you can see, there are plenty options available if you need to address issues with your debt to credit ratio, either before or after closing a credit account. Even if you are just trying to build credit and don't have a lot of credit available to you here and now, you have several options and tools at your disposal for improving your debt to credit ratio, and in turn, your credit score.