March 19, 2016

How Closing A Credit Card Affects Your Credit Score

There are no boundaries to how a credit card can step in to draw you out when you are in hot soup, just like a good old friend. But this “friend” has its limitations. If not kept under a watchful eye, it may leap out of bounds and lead you to a dreaded financial nightmare. Confused? Let’s make it simple for you.

Credit Card = Friend or Foe?

You have a monthly income of let’s say, Rs. 50, 000/- and you have 2 credit cards with limits of Rs. 75, 000 each. This means in any month you can spend money that is equal to your income plus credit limits. In this case, it will mean you can make purchases of Rs. 50, 000 (salary) + Rs. 75, 000 (credit limit on card 1) + Rs. 75, 000 (credit limit on card 2)= Rs. 2, 00, 000! Thus, with an income of merely Rs. 50, 000 you are actually able to spend way above your means all with the help of a credit card. So, it’s a friend.

Credit Card Affects Your Credit ScoreBut wait. The expenses made through your card have to be returned after a month to the company that has issued this card to you. You have an outstanding balance of Rs. 1, 50, 000/- on your cards and no balance in your salary account, as you have spent it. Once you receive a credit for Rs. 50, 000 towards your salary you will be able to pay only one third of your outstanding bill. The balance will roll over to next month with an additional interest charge. It will take you months to clear this outstanding debt. So, it can be a foe too.

While spending and repaying the credit card do not improve CIBIL score, but how much you are spending and how much of that are you repaying does have a signification bearing on your CIBIL score.

Let me get rid of it!

A lot of people would be quick to conclude that neither will there be a card nor will there be any outstanding bill. Assuming this many people would rush to cancel their cards. Like the two sides of a coin, closing a credit card has dual effects on your score.

One aspect of credit cards in your financial portfolio is how many credit cards you have. If you apply for credit card nonchalantly, it can harm your credit score. One main reason for it is because credit cards are a form of unsecured loan. Unsecured loans attract higher rate of interest as they are more risky from the point of view of lenders.

Another aspect of having credit cards is credit utilization ratio. Let us continue with our example. You have an available credit of 1, 50, 000 but you use not more than 30, 000 in any month. As per a simple calculation of credit used divided by credit available, you are not using more than 20% of credit. This means you are not an aggressive user of credit. You cut down on one card. Now the available limit is reduced to 75, 000 but you continue to use it for 30, 000. Here your utilization ratio increases to 40%. You have doubled your credit utilization without increasing your spending. This will bring down your score.

If the fraction of unsecured loans in your financial portfolio is higher than secured loans, coupled with a higher utilization ratio means that you will have larger payments with higher rate of interest and the likelihood of you coming under debt burden will be great. This is one reason why lenders will be averse to extending further credit to you.

Having too many credit cards and higher available credit limit also make prospective lenders wonder on why you need so much credit. They may also assume that you are seeking more credit to wriggle out of existing debt burden.

Then what shall be done?

Firstly, do remember that a good score alone is not a promise for easy borrowing. All your financial activities are recorded in detail in your CIBIL report. A lender is likely to take both of them into consideration while evaluating your loan application.

Secondly, if you have to close a card, then close the one which is more recent. Any cards that are old must be kept open as they have little impact on score.

Plan in advance. It means, if you do not foresee to apply for fresh loans for at least six months then you can cancel a card today. The impact on your score will wear off with timely repayments.
And most importantly, don’t let your credit score alone be a factor in deciding whether you should or should not close your card. If you feel that a card is posing a risk of being lost and misused because it is sitting idle, is attracting a maintenance charge though you don’t need that card or if you are already in a debt soup, then go ahead and close that account. You can offset the effect on your score by paying off existing balance and over time with the help of diligent payments.

To put it briefly

Yes, cutting down on your credit cards will hurt your CIBIL score. Mostly, a lower credit utilization ratio is considered less risky. But to keep a low ratio investing in more and more credit cards is not a wise decision either. Strike a balance between the two and maintain discipline in your finances by paying off balances on time. This is will keep you out of debt stress.

written by Arun Ramamurthy, author of “Unlock the Power of Your Credit Score” : India’s first book on credit scores India’s first book on credit scores.

                                                                      - When credit is your need, there is a credit card indeed.