The Surprising Downside of Cutting Up Your Credit Cards

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Cutting up your credit cards
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It's a time-honored tradition for shopaholics: When you realize your spending has spiraled out of control, you take out your scissors and cut up the credit cards that have been getting you in trouble.

If you're getting out the scissors to destroy your plastic, presumably you're also picking up the phone to cancel the account itself. But is that such a good idea?

If the goal is to rein in your spending, there are good reasons to kill some accounts altogether. The prevalence of e-commerce has made it easy to buy nearly anything without a physical card, so if you've got your credit card info stored in your Amazon account, just cutting up the card won't do much. And leaving the account open means that you could, in a moment of weakness, ask your bank to send a new card.

In that case, simply cutting up your cards is a meaningless gesture unless you're also closing the account. But there's a good counterargument: Closing accounts could hurt your credit score.

"Generally the advice is that you not close accounts, especially if you're planning to apply for credit in the near future," says Rod Griffin, director of public education for Experian. "The reason is utilization, which is the second-most important factor in credit scoring."

Utilization is a simple calculation: It's the ratio of your total credit card balances to your total credit limit. The higher the utilization -- the more of your total available credit you're using -- the worse the impact on your credit score.

For example, say you have two credit cards, each with a $10,000 limit, and a total of $8,000 in debt between the two cards. Your utilization ratio is 8,000/20,000, or 40 percent. If you do a balance transfer to put all the debt on one of the cards and cancel the other account, you shrink the denominator of that fraction to 10,000. Now your utilization ratio is 8,000/10,000, or 80 percent. You owe exactly the same amount as you did before, but ratings agencies see you as riskier, and ding you accordingly.

So if by closing some accounts, you're simply shifting most of your spending and debt onto other cards, you're hurting your credit score to little benefit. On the other hand, if you're also reducing your debt and credit card spending as you close your accounts, the impact on your score will be minimal.

Another thing to consider before closing your account is the age of the account. While not as important as utilization, the length of your credit history also factors into your score, so it's best to shut down "younger" accounts rather than the credit card you've had since college. (With that said, closing an old account won't wipe out the good credit you've built up from years of paying bills on time.)

In any case, Griffin says that you shouldn't let credit-score concerns totally dictate your financial decision-making.

"Even though your credit score may be hurt a little bit, you still may want to close accounts based on your overall financial situation," he says. "The first thing you need to do is eliminate the temptation to accumulate more debt."

If there are ways to completely eliminate that temptation -- for instance, by removing stored payment information from your e-commerce accounts -- then it may be worth it to kill the plastic but leave the account open. But if you think the bad habits that got you into debt in the first place may resurface, then don't leave it to chance: Call up the bank and do what needs to be done.

Matt Brownell is the consumer and retail reporter for DailyFinance. You can reach him at Matt.Brownell@teamaol.com, and follow him on Twitter at @Brownellorama.


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