To answer this question we need to review the definition of credit and why we use credit. Credit is the agreement to pay for something in the future which you have already received. Two types include revolving credit, credit cards for example, and installment credit, car notes and personal installment loans are examples of these.
Most people will use credit at some time in their life, but credit must be built from scratch. For some, opening a small limit secured credit card or taking out a personal loan is where they begin. If you have a credit card and you’ve recently paid it off, it may be tempting to celebrate by calling the company and cancelling the account. Before you do, there are a few things about how cancelling credit cards can affect your credit score that you should know.
Typically, the following information is sent to the credit bureaus about your account. Your credit limit, balance, monthly payment amount, and your account status. The status will reflect if your account is current or past due. Let’s say you paid off your credit card, but you had a few late payments along the way, and now you are thinking about cancelling the card. Here’s why you shouldn’t. An easy way to imagine how you build credit is having more positives than negatives on your report. Credit scores are made up of multiple factors, and one is the average length of time your accounts have been opened. The longer you have an account, whether or not you use it, is usually seen as a positive by the credit bureaus. Another factor is your credit to debt ratio, and having a zero or a low balance can also be positive.
Here’s how your credit to debt ratio or credit utilization rates works:
If you have three credit cards with credit limits of $300, $500, and $750, you have $1,550 of total available credit. If you have balances of $250, $450, and $750 you are using $1,450 of your available credit, or 94%.
Paying off the balance on the largest card means your new available credit will be $850 or 55%. This has a positive effect on your credit utilization ratio and could give your credit score a boost if you leave the line of credit open. Closing the account removes $750 from your available credit.
The variety of credit also contributes to part of your credit score. So, keeping your credit card open and having an installment loan demonstrates the ability to handle different types of credit. As an alternative to using credit cards to cover unexpected expenses, a personal installment loan may be easier to fit into a budget. Unlike credit cards where payments vary based on the balance, payments remain the same and are for a fixed term. They also allow you to build equity, which can give you access to cash by refinancing or resetting the loan. With all lines of credit, the most important thing is making your payments on time.
Everyone’s situation is different, of course. In general, having and keeping different types of accounts open and in good standing, will continue to create positives for your credit.
For more great information on all things credit-related, head to our 'Basics of Credit' reference page.