Risk & Compliance More Scoring Myths: Closing Credit Cards

Jul052011

Recently I blogged about common FICO® Score myths. Here’s another widespread misconception: People believe that their credit scores should improve when a credit card account is closed. Not true. In all likelihood, closing a revolving credit account either will not affect the FICO® Score at all, or it will cause the score to drop slightly.

The myth seems to be based on the notion that if someone has lots of untapped credit available, he could conceivably use it all up in a short time, become maxed out, and pose a much greater threat to default. But generally people do not go credit-mad one day and spend money like maniacs. Over the years, FICO has consistently found that a characteristic of low-risk consumers is they have access to significant amounts of credit but use it sparingly. This correlation has been proven mathematically beyond question.

Closing-Credit-Cards 

The “why” is less well known. It may be that these borrowers have the willpower to resist the siren song of untapped credit, instead carefully restricting their borrowing to stay within their means. This applies equally to low-income consumers and to millionaires. On the other hand, it could be that consumers with large amounts of untapped credit have a larger “safety net” that allows them to temporarily cover their financial obligations with this available credit and weather the storm until they get back on their feet. It could even conceivably be a combination of both profiles.

Closing a card account can cause a person’s FICO® Score to drop when it results in a higher utilization rate—defined as the total outstanding debt divided by total available credit. That rate is factored into the “Amounts Owed” part of the scoring model, which generally accounts for about 30 percent of a consumer’s score.

Impact to the FICO® Score is less likely, however, if the consumer habitually keeps balances on credit cards low. Then closing an account, and therefore lowering available credit, is less likely to significantly increase the person’s aggregate utilization rate.

A related myth holds that closing a credit card account shortens a person’s length of credit history, thereby hurting the FICO® Score. That notion is incorrect too. The FICO Score considers the age of both open and closed accounts. When an account is closed, it usually remains on the credit report for many years. The FICO Score will continue including that closed account in its assessment of length of credit history.

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