Credit scores are critical in obtaining a loan

Most people are now aware that one of the most important criteria that a lender uses when you apply for a loan is your credit score. Also known as a FICO score, this number, which ranges from 300 or so to 850, is a distillation of your entire borrowing history, reduced to a three digit number. Other factors are certainly important, such as your salary, your length of employment and the amount of time you have been living at your current address, but the credit score will be the most important factor in determining whether or not you get the loan you want and whether or not you get that loan at a favorable interest rate.

People who find that their credit score is sub par are often eager to repair it. That’s fine, and paying off your existing or overdue debts is a great start towards doing just that. But many people often think that they can improve their “lendability” by closing accounts. One would think that closing an account would be a positive move. After all, if you close an account, you can’t borrow against it anymore, thus reducing a possible source of debt. And yet, closing an account often causes credit scores to go down, rather than up.  That may seem rather counterintuitive. Why would that happen?

Your score can be adversely affected in two ways by closing an account. We will explain why.

Your credit score consists of a number of components, which factor in how much credit you have, how long you have had it and whether or not you have a history of paying off your debts. Other items of note, such as previous bankruptcy filings, are noted, as well.  Your history shows how long you have had credit, and a lenders tend to look more favorably upon borrowers who have long histories than those who have short ones. If you cancel an account that you have had for a long time, it will have the effect of shortening your history. If you closed an account that you had for ten years and you only have one remaining that you have had for five years, it effectively reduces your history to five years. Canceling an account that has had a short life, such as one you opened last year, will have less of an overall effect.

The other problem associated with closing an account is that it may raise the debt to credit ratio. Lenders like to see that borrowers are living within their means and not borrowing against all of their available credit. A good rule of thumb is to keep your debt limited to no more than 30% of your available limit, although some lenders will accept 50%. But suppose you have two accounts, one with a $5000 limit that is maxed out, and one with a $20,000 limit on which you owe nothing. Your total debt is $5000 against a total limit of $25,000. That represents a 20% debt load, and lenders will be OK with that. But if you close that $20,000 account, thinking that you will improve your score, you may be shocked at what happens. Your debt load will increase from 20% to 100%! You are now at your limit on your only available account!

If in doubt as to what you should do to keep your score in good standing, you may wish to consult with a reputable credit counselor.

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