Thinking of closing a credit card? Here’s how it impacts your credit score

It’s December, and the calendar year is coming to a close soon. The year-end is a good time to review, reflect on the past year, and prepare for the coming year. As part of your year-end financial review, you may decide to close one or multiple credit cards for various reasons. In this article, we will understand why people close credit cards, how it impacts their credit score, and whether one should be concerned about it.

Reasons why people close credit card(s)

There are various reasons why people decide to close their credit card(s), some of which are as follows.

1. You have taken a new credit card with better features and benefits, due to which you are no longer using your existing credit card.
2. The bank has made significant changes or devalued the features and benefits of the credit card, rendering it less useful than it was previously or compared to other cards on the market.
3. The bank has increased the fees on the credit card, reducing the value proposition.

Impact of credit card closure on credit score

Closing a credit card may result in a marginal fall in your credit score. The reasons for it include the following.

1. Change in the credit mix: Credit mix is one of the parameters used in calculating an individual’s credit score. A healthy credit mix strikes a balance between secured loans (home loans, vehicle loans, etc.) and unsecured loans (personal loans, credit cards, etc.).

A healthy credit mix contributes positively towards enhancing an individual’s credit score. When you close a credit card, it can impact your credit mix. Let us understand this with the help of an example. Suppose you have a home loan and a credit card. So, you have a mix of one secured and one unsecured credit product.

When you close the credit card, your credit mix changes. So, now you have only a secured credit product and no unsecured credit product. This change in the credit mix in favour of secured credit products will adversely impact the credit score.

Recommendation: When closing a credit card, make sure there is no or minimal impact on your credit mix. It will ensure the marginal fall in your credit score is temporary.

2. Reduction in credit ageing: Credit ageing is one of the factors considered while calculating an individual’s credit score. The longer the age of a credit product, the better it contributes towards enhancing an individual’s credit score.

You decide to close a credit card that you have been holding for many years. Suppose the age of the credit card being closed is the highest in your credit portfolio (including all existing loans and credit cards). In that case, it will reduce the overall portfolio credit ageing. Thus, the reduction in credit age, with the closure of the oldest credit card, will adversely impact the credit score.

Recommendation: If you have an old credit card that is lifetime free, consider retaining it instead of closing it. If the card has annual fees, check with the bank if they can convert it into a lifetime-free card. Once the card becomes lifetime free, use it for a small transaction every few months to keep it active. That way, the longer you hold a credit card, the higher the credit age, and the better it will contribute towards improving your credit score.

3. Increase in credit utilisation ratio: The credit utilisation ratio measures the percentage of credit utilised from the total credit limit available. Suppose you have two credit cards with a total credit limit of Rs. 5,00,000 (one card has a credit limit of Rs. 2 lakhs and the other card has a credit limit of Rs. 3 lakhs). You spend Rs. 1 lakh, spread across the two cards, every month. Your credit utilisation ratio is 20%.

A credit utilisation ratio of 30% or lower contributes positively towards improving your credit score. Now, suppose you close the credit card with a credit limit of Rs. 2 lakhs. You shift your entire monthly spend of Rs. 1 lakh on the credit card with a credit limit of Rs. 3 lakhs.

After closing one credit card, your credit utilisation ratio has shot up to 33.33% from the earlier 20%. The increase in the credit utilisation ratio above 30% will adversely impact your credit score.

Recommendation: Before closing a credit card, check the impact of the card closure on your credit utilisation ratio. After the card closure, if the credit utilisation ratio is expected to exceed 30%, check with the bank if the credit limit on the other credit card can be increased.

Share your latest income documents with the bank and request a credit limit enhancement on the other credit card. With a higher credit limit on the other card, if the credit utilisation ratio stays below 30%, you can go ahead and close the credit card that you no longer intend to use.

4. Halt in building the credit history: For new-to-credit customers, it usually takes around 6 to 12 months to build a decent credit score with a loan or through regular monthly credit card usage. Suppose you are a new-to-credit individual who has taken their first credit card and has just started building their credit score and history.

In such a scenario, if the credit card is closed in less than six months, it will halt the progress in building a credit score and history.

Recommendation: For new-to-credit customers, a credit card is one of the most effective tools to develop a good credit score and history. If you have taken a credit card to build your credit score and history, consider using it for a year or so. In one year, with regular monthly usage and timely payments, you will develop a good credit score and history. A good credit score and history will further help you in the future to obtain a home/vehicle loan, or any other loan, when you need it. Some banks give concessional interest rates on loans for borrowers with a higher credit score.

Should you be concerned about the fall in your credit score?

The fall in the credit score due to credit card closure is usually marginal and temporary in nature. If you follow the recommendations suggested in the article, you will be able to minimise the fall in your credit score due to credit card closure. Also, usually, a fall in the credit score is temporary in nature. When you take steps like maintaining a credit utilisation ratio below 30% along with timely monthly payments, the credit score will recover in a few months. Hence, you need not be alarmed about the fall in your credit score due to credit card closure.

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached on LinkedIn.

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