People are often advised to close down extra credit cards to save money. Having multiple credit cards can sometimes make it easier to spend money that you don’t have. This is particularly true if you are someone who finds it hard to stick to a budget or given to impulse shopping.
Cancelling a credit card you no longer use can also help you save on the annual fees and charges, helping to reduce the stress on your household budget. But did you know cancelling your credit card could hurt your credit score in some cases instead of helping it as you expected?
Cancelling a credit card and your credit score
Your credit score is based on your credit file, which includes information about your credit accounts. Closing any credit account, including your credit card, will lead to a change in your credit file that’s likely to impact your credit score. However, whether closing a card will improve your credit score or reduce it depends on multiple factors, such as the number of active credit cards you hold, the length of your credit history, and the amount of debt on your file.
When does cancelling a credit card can hurt your credit score?
Cancelling a credit card is generally a step in the right direction when you are struggling with debts or finding it difficult to control your spending. However, if you only have one credit card, closing that account could hurt your credit score by limiting the amount of credit information available on your credit file.
In general, it’s not the act of closing a credit card that affects your credit score but the positive or negative reporting information associated with the card or your repayment history. Australia follows comprehensive credit reporting, which means both positive and negative financial activity is reported to credit bureaus. If you have a credit card that you always paid off in time but no longer need or want for any reason, closing it down will also remove the positive credit history associated with that card from your file. This could lead to a potential dip in your credit score.
If you plan to close a credit account to apply for a new one, it could harm your credit score, even if you think the new card is better suited to your requirements. Each time you apply for a new credit product, the credit provider pulls out your credit file to assess your suitability for credit. This is also known as a hard enquiry, and every new hard enquiry is noted on your credit file and reduces your credit score slightly.
While one or two hard enquiries might not significantly impact your credit score, having multiple credit enquiries on your file can indicate to lenders you are having trouble managing your finances or are otherwise credit hungry.
If you really want to switch credit cards because you are getting a lower interest rate or a better deal overall, you might want to consider the pros and cons of the situation before jumping ship. In case you are switching cards for the first time, it might not affect your credit score after all.
Is there any way that cancelling a credit card will help your credit score?
Even though cancelling a credit card might adversely impact your credit score, it might be a good decision for your financial situation if you are already struggling with debt.
For instance, if you think cancelling a credit card could help bring your finances on track by controlling your spending or reducing debts, the benefits to your financial position might outweigh the harm to your credit score. Continuing with a credit card when you can’t manage your spending might lead to missed repayments that can adversely impact your credit score. Closing your credit card in this situation might be helpful for you.
Sometimes, closing a credit card can also improve your credit score by reducing your debt-to-income ratio (DTI).
Your debt-to-income ratio is the amount of debt on your file in comparison to your overall income. While calculating your total debts, lenders tend to take into consideration your entire credit card limit if you don’t owe anything on the card. Having a high debt-to-income ratio can lead a lender to reject your application for credit as a large percentage of your income goes towards servicing your loans, leaving little for day-to-day expenses.
If you are applying for a major loan product like a home loan, you might want to check your DTI and bring it down by cutting additional credit cards. Alternatively, you might want to ask your credit card provider to reduce your credit card limit.
The bottom-line
If you plan to cancel a credit card because you no longer want it or use it for some reason, it’s worth considering the impact both on your credit score and financial situation. Generally, if cancelling the card will improve your financial situation, you can overcome a temporary shift in your credit score by following good financial habits, like paying all your other bills on time after closing the credit card account. However, if you only have a single credit card and no any other form of credit history, you might find it challenging to apply for future credit because your credit file will not have much information to calculate your score.
In case you are struggling with debt and not sure about the right approach to deal with your finances, you could consider reaching out to the National Debt Helpline to seek advice from a financial counsellor.
