Done With a Credit Card? How Exactly It Will Impact Your Credit Score

In the time since the end of the recession, a large number of Americans have made it a priority to reduce their credit card debt, in some cases considerably. But one quandary many may face once they have successfully reduced one or all of their cards' balances to zero is figuring out what they should do next.

If you're like millions of Americans, you probably loaded up on credit card debt during or following the recent national downturn, or at least took on more than you were used to carrying prior to that time. But once the economy began improving, you and many others may have begun chipping away at those bloated balances in an effort to get your debt back under control. Doing so will give you two advantages going forward: First, you'll have more money every month because your minimum payments will decline as your balance falls. Second, your credit score will start to improve, and the closer to zero you get the better off you'll be in this regard.

But getting down near a zero balance likely leaves you at a crossroads. On the one hand, closing your credit cards after you pay them off in full is a great way to avoid the temptation of spending on them, and potentially landing yourself in more debt trouble if you ever have another financial emergency. On the other hand, closing your cards will also likely diminish your credit score — in some cases considerably — and as a result, you will have to think carefully about how you approach the issue going forward.

Why closing them might not be a good idea
The reason why it's not smart to carry a large credit card balance is that a full 30 percent of your score is made up entirely of the amount of debt you have in your name at any one time, when viewed as a percentage of the limits on all your combined cards. So suppose you have $5,000 in debt across four credit cards with a combined maximum of $10,000. That means your "credit utilization ratio" is 50 percent, and that is considered too high; to have a more or less perfect rating in this aspect of your score, your debts will have to total 30 percent of your limits or less, meaning that you'll have to cut out at least $2,000 worth of debt on those cards to get to where you need to be.

But once you get past that point, and are getting down to very small balances on any given cards, you might want to think about your next move. Let's say you're down to only owing $250 on a card with a $2,000 limit. You could reduce that balance to zero in just a payment or two, but at that point, closing out the card altogether would likely be a bad idea.

The reason why is related to your utilization ratio: If you cancel that card, you're effectively increasing your ratio again. Let's say that even after paying that card down, you still owe another $3,500 on your other accounts. That's pretty close to the 30 percent mark when your limit is $10,000, but closing that one card will slash your total maximums to just $8,000. Thus, your ratio skyrockets from 35 percent ($3,500 out of $10,000) to almost 44 percent ($3,500 out of $8,000).

For this reason, it might be wiser to keep all your cards open, at least until you've done enough that you've paid down all your accounts to very low levels that would not disrupt your ratio if any one or more of them were to be shut down.

What should you do instead?
Even if you're on a mission to reduce your chances of racking up credit card debt, it might be wise to at least keep one of those accounts (probably the ones with the largest limits or most affordable terms) open, even if you have no plans to use them. This will be helpful in case you ever run into a financial emergency, and don't have the necessary cash on hand to pay for a car repair or something else that would cost you a significant amount. This gives you the necessary flexibility you might need but also limits the amount you'll be able to rack up at any one time.

Another part of making sure your credit score is as high as possible, of course, is ordering copies of your credit report and checking to make sure there are no unfair markings listed in your name. If you discover any such entries on these documents, it could be helpful to contact a credit repair law firm to help you sort out the issue as quickly as possible, and return you to where you deserve to be.