As people have vented their wrath at banks for raising the cost of credit cards -- higher interest rates, new annual fees and lowered credit lines for a lot of loyal customers -- a recurring theme of the discussion is that consumers will end up punishing themselves by closing their credit-card accounts in a fit of anger. As one reader of a post about credit-card fees commented last week,
I think that the system of credit scoring needs to be addressed. The banks and credit card companies are abusing the current scoring system. They know that that if the account is closed the consumers score will go down and that is something the consumer will not want.
After all, these scores are used not only by lenders to determine whether they'll front you money and how much interest they'll charge, but also by a lot of other people who want some insight into your trustworthiness: Auto-insurance companies, for starters. Potential landlords. Companies thinking about hiring you.
But is this a real problem?
Will indeed your credit score drop if you tell your card issuer to stick their plastic somewhere other than an ATM? Part of the problem is that the methodology of determining your credit score is a secret formula held by FICO, a.k.a. Fair Isaac, the company behind the most widely-used credit scoring system in the US. Yes, they do explain the ingredients of that formula in general terms. Getting the nitty-gritty numbers, however, is like asking Coca-Cola for their secret recipe: They'll admit it contains "natural flavors," but don't expect much more information than that.
Yet FICO was able to shed some light on the question. The most important point made by spokesman Craig Watts is that it's a myth that if you close a credit-card account, all trace of it disappears from your credit score. In fact, he says, the credit agencies from which FICO draws information used to calculate your score hold on to payment history for years -- the positive stuff for about a decade and the negative stuff usually for seven years. That information is used to calculate two parts of your credit score. One is payment history, which accounts for 35% of your score and which reflects, among other things, whether you made your payments on time and whether you welshed on any balance you may have owed when you chopped up your card. Another is length of credit history, accounting for 15% of your score, which reflects whether you're a newcomer to paying people back or not. All that stays, Watts says, if your card goes. You've read -- perhaps from well-meaning people on FICO's own message boards -- that you should never close your oldest credit card because your length-of-credit-history measurement will immediately plummet? Again, that's a myth, says Watts. (Dropping it might affect your credit score a decade from now, he grants, but the impact will be small potatoes compared to that of your credit-related behavior in the interim.)
Where you may get into trouble right now is in the "amounts owed" area, which accounts for another 30% of your score. One important element of that is what's called credit-card utilization -- that is, the size of the balances you carry on your credit cards as a percentage of the amount you could theoretically borrow on all your cards. Imagine, for example, that you have two credit cards with $5,000 limits on each, with a $500 balance on one and a zero balance on the other. If you close the zero-balance account, you've gone from using 5% of your available credit (the $10,000 total on your cards) to 10% (of the $5,000 on the remaining card) -- not a big deal in credit-card terms. In low-utilization situations such as that, closing an account should have virtually no effect on your credit score, says Watts. "No harm, no foul," he says.
But let's say instead that you have three $5,000-limit cards -- one with a $3,000 balance and the others with none -- and you drop your two zero-balance cards. In this case, your credit-card utilization rate will go from 20% to 60% -- a noticeable amount that will certainly ding your credit score. How much? Can't say, since we're back to the black-box credit-scoring system.
In any case, Watts says that if you already have a score in the upper half of the 700s or above -- that's about 40% of the population -- losing a few points shouldn't hurt you at all, practically speaking.
So if you want to chop up your credit card, start chopping. The downside is probably a lot smaller than you think.
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