Do I allow my credit card company to close my account in lieu of lower interest rates?
Credit card companies are aggressively closing credit card accounts and/or reducing credit limits. In theory, this can decrease your credit score. Part of your credit score comes from a formula called the credit utilization ratio. Simply put, this is a look at how much total credit limits you have available to you versus how much of that credit limit you are using. For example, if you have $20,000 in credit limits and you are using $10,000 of that $20,000 in credit limits, you are utilizing 50%. Ideally you want that ratio lower then 30%. As that ratio goes up, your credit score goes down.
So it stands to reason that if an account is closed or a credit limit is decreased, your utilization ratio could increase. Let’s go back to the previous example. At this point you are using $10,000 of the $20,000 credit limit that has been given to you which makes your utilization ratio 50%. Let’s say that the credit card company decreases your credit limits by $5,000. Now you have $10,000 worth of debt and in total $15,000 of credit limit. Now your credit utilization ratio is 66%! OUCH!!
Of course, credit scoring is formula based and depending on what is on your credit report determines the positive or negative impact on your credit score. FICO just did a study to determine how the credit scores of consumers are affected when credit limits are reduced and accounts are closed. The results were a little surprising. They basically took consumer credit reports and ran hypothetical scenarios. The moderate scenario decreased credit lines up to 10%. The medium scenario decreased lines up to 25%. The severe scenario decreased credit limits up to 50%. Here were the results:
Moderate Scenario – 84% of those tested had no change in their credit score
Medium Scenario – 68% of those tested had no change in their credit score
Severe Scenario – 56% of those tested had no change in their credit score
Of course everyone’s credit report is unique. The effect of a closed account or a decrease in credit limits could or could not negatively effect your credit score based on the overall credit profile, the % reduction, and/or whether the reduction or closure causes the consumer to miss payments or take other actions.
Here is the bottom line of when you should and should not close an account. Obviously, a credit limit decrease is out of your control.
- RULE OF THUMB
Only close a credit card account in the event that it allows you to keep a favorable interest rate. If by keeping it open your interest rate goes to 30%, then let them close it. Otherwise there is not any significant downside to keeping your credit card account open.
