It recently occurred to me that many of my peers have heard that it’s not a good idea to cancel an old credit card, but don’t know why. The reason unused credit cards with no balance can be beneficial lies in the esoteric Debt to Credit ratio. I discovered the Debt to Credit ratio after watching TV programs like the Suzie Orman Show and CNBC’s On the Money. These shows helped explain the logic, reasoning, and consequences that lie behind the common truism of not canceling an old credit card.
Initially, it seemed unnecessary for me to keep an open account with my first credit card from college. I no longer use it due to the out of date rewards program, high interest rate and a low credit line. Thinking the benefits of keeping an unused card open to be a myth, I canceled my first credit card a few years after opening it. However, when I realized the adverse effect this action had on my overall credit score and available credit, I had no choice but to declare this myth a reality.
The Debt to Credit ratio determines the percentage of total available credit a person is using. In this equation the total available credit serves as the denominator (read: bottom number), while the numerator (read: top number) is your total debt outstanding i.e. total amount owed. This equation can be applied on an individual card level, or as an aggregate. The sum of all your outstanding debt over the total credit available to you reflects the proportion of credit you are using – the smaller that percentage, the better.
How Does Canceling a Credit Card Hurt Me?
Canceling a credit card that is not being utilized does not change the part of the equation which reflects total debt (numerator). It does, however, decrease the total available credit (denominator). As a result, at a given amount of outstanding debt, a decrease in the amount of total available credit gives the illusion that a higher proportion of the credit available is being used.
Lets look at an example:
Say I have 5 credit cards with $1,000 available credit limits on each, giving me a total of $5,000 in available credit. I really only use 3 of them each month, with my total combined balance being $500 (it doesn’t matter if the balance is paid in full each month, the balance that existed at each statement date is used) So $500 / $5,000 = 10%, meaning, I am using 10% of the credit extended to me. Let’s say I decide to close the accounts of the two cards that I do not use ($1,000 available credit on each). Now my denominator is $3,000. That same $500 outstanding balance now represents over 16% of my available credit. My Debt to Credit ratio just increased by over 6% even though my spending habits have not changed.
Rule of Thumb
From the TV programs mentioned earlier as well as research I’ve done online, I find that its a good goal to keep the Debt to Credit percentage below 20%. This only represents revolving debt (i.e. credit cards) and not installment debt (student loans, car loans, etc). The 20% goal can apply to any particular card, as well as in aggregate.
It’s easy to forget about store charge cards (discussed in a previous post), which is troublesome since they negatively impact the ratio the most. The low spending limits on store charge cards mean that almost any spending can exceed the 20% usage goal. For example: A card with a $500 limit, restricts the user to keeping less than $100 balance in order to stay under the 20% usage goal.
I’ve decided to add up all my 2 credit cards and 1 store charge card to calculate my Debit to Credit percentage. I’m using the average monthly balance from Jan – July 2009 on each card to get a more accurate ratio.
Overall Total: 608 / 14,200 = 4.28%
After going through this exercise, I’m happy to see that I’m averaging less than 10% usage on each card. An area of improvement would be to even out the spending over the two credit cards or use the one with a higher limit more often. Keeping in mind that some months I spend more (especially when major purchases are involved), at least I have a good cushion to still stay under 20%.
Those are my numbers, I’m interested to see if anyone else goes through the exercise and has any findings you would like to share.