THE BLOG

If You Read One Article About Dropping Credit Cards, Read This One!

03/07/2014 02:20 pm ET | Updated May 07, 2014

The media is hyping it up all over the place. The economy is improving, Real Estate is coming back in many areas and the sun is shining bright today. With all this media hoopla popping up, many folks are starting to look at that stack of credit cards in their wallet and wondering what to do with them. They know they need to do something about their sagging credit score. Those extra credit cards sure look like a great place to start. Should you hold on to them and even break 'em out every now and then to boost your credit score? Or would you be better off just saying Good Bye and Good Riddance?

First up, make sure you understand your credit card is not like a hot potato. You don't have to drop it today. In other words, be careful about impulse decisions that may come back to haunt you later.

Conflicting Advice from the pros?
Unfortunately, if you take the time to Google dropping your credit card you will get all sorts of results. You will find pundits that warn against dropping your credit cards. On the exact same search results page you find another so-called eggspurt spouting the exact opposite advice. Worse still, some of these suggestions are (to put it nicely) just plain wrong. Lets look at the realities of those credit cards in your wallet.

There is NO EASY BUTTON here.
Sorry, but the fact is that holding on to or dropping a credit card is not a simple yes or no. Yes, of course, if your spending is completely out of control, and if dropping gets you back your financial life sure. But for most people, the reality is somewhere in between. In that case, let's take a look at some facts about credit cards and your credit score.

Look at a quick rundown of your credit score and where and how your credit cards matter The single biggest factor with your credit score (FICO score) turns out to be your payment history. A whopping 35 percent of your FICO score. That's huge. But get this. Closing a credit card account won't affect that number for up to 10 years down the road. Why?

It's all due to how your credit score is calculated. Suffice it to say the bad stuff, say late payments to your credit card company, stay with you for 7 full years. Ouch! But wait, it works the other way too. The good stuff, like consistently paying your credit card bill, stays with you for 10 years. Bottom line? Dropping that credit card will not affect this piece of your credit score for quite some time.

The next big piece of your credit score pie comes from what those credit reporting agencies refer to as your utilization ratio. In everyday talk, that simply means how much you owe compared to how much you can borrow. For example, suppose you have you have a $5,000 personal line of credit at your neighborhood bank. If you borrowed $4,000 from that personal line, now your utilization ratio is 80 percent. (In other words, 4,000 divided by 8,000 gives you 80 percent utilization ratio.) For the record, lenders don't want to see this number much more than 30 percent for all of your credit combined.

How does this work with your credit cards?
Now this is the point you want to scooch up real close and pay close attention. The details may at first seem arcane and out of this world. Yet, its really easy to understand once you read through it one time. Here goes: closing or canceling a credit card starts a snowball effect that will give your credit score a wallop it may not be able to stand.

It works like this. Suppose, like most Americans you carry at least 2 credit cards in your wallet. Furthermore, assume that each credit card has a generous $5,000 credit limit. On one card, you carry a $4,800 balance. The other card only has a $297 balance. If you had not first read this article you might be sorely tempted to go ahead and pay off the credit card with the $297.00 balance and then cancel it thinking you will be rewarded for your good deed. Ooops, not so fast.

Watch what happens next. If you ignore all your other credit for a moment, with those 2 credit cards you had a total credit of $10,000 and a credit utilization ratio of 50 percent. Not so good, but then again, not terribly bad. But, now you cancel the second card. All of a sudden, you have a total credit available of $5,000. Yet, your credit utilization ratio is more than 90 percent (4,800 divided by 5,000 equal 96 percent).

Kapow!
Now your credit score takes a dive and you are left wondering what just hit. It gets worse. Since your credit score just nosedived, you are most likely not going to be able to replace that card anytime soon.

So where does that leave you?
Are you starting to feel like you are (insert your own expletive right here) if you do or (insert your own expletive right here)if you don't? Look, you want to walk away from this article armed with the facts. Yes, of course there situations when it makes cents (pun intended) to cancel a credit card. But before you do so, make sure you understand the possible negative effects on your credit score. Now that you are armed with the facts, a better choice might be to know the ins and outs of your credit as found here at http://www.yourfinancessimplified.com/secrets-revealed-your-insiders-guide-to-personal-credit-repair/

Video Powered by Bank of America: