When to Cancel a Credit Card? 10 Dos and Don’ts to Follow

Maria O. says:

I’m a huge fan of the Money Girl Podcast and am also a Get Out of Debt Fast student. I’ve taken your financial advice and am glad to say that my husband and I are in a much better financial situation now.

We both have travel rewards credit cards with zero balances that we haven’t used in over a year. We know that canceling cards isn’t advisable, but we really want to stop paying the $95 annual fee. My husband’s credit score is 780 and mine is 818. What do you recommend?

Maria, thanks so much for your question and for being a part of the Money Girl community!

Before you cancel a credit card, it’s critical to understand how it will affect your entire financial life. Whether you should get rid of a card depends on a variety of factors, including your future financial goals.

In this post, I’ll cover 10 dos and don’ts for when to cancel a credit card. You’ll learn how to manage these accounts wisely so they improve your finances and don’t hurt them.

Before I cover each of these dos and don’ts, here’s an overview of why building good credit and using credit cards the right way is so important.

The benefits of building your credit

Having good credit simply means that you have a reliable financial track record according to the data in your credit history with the nationwide credit bureaus: Equifax, Experian, and TransUnion. Different credit scoring models use that data to calculate credit scores, which act as shortcuts for various businesses to evaluate you quickly.

When you have high credit scores, potential lenders and merchants have more confidence that you’ll be a good customer who pays their bills on time. That’s an incentive for them to give you top-tier offers, which saves you money.

Having good credit scores allows you to get the most competitive interest rates and terms when you borrow money using credit cards, mortgages, car loans, student loans, and personal loans. For instance, paying just 1% less for a mortgage could save you over $100,000 on the cost of a 30-year, fixed-rate loan, depending on the total amount you borrow.

However, even if you never borrow money to finance a home or charge a vacation to a credit card, having good credit gives you other significant benefits, including:

  • Lower auto insurance premiums (in most states) 
  • Lower home insurance premiums (in most states) 
  • More opportunities to rent a home or apartment
  • Lower security deposits on utilities 
  • More government benefits 
  • Better chances to get a job

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The Connection Between Credit Cards and Your Credit

The only way to build credit is to have active credit accounts in your name and to use them responsibly over time. That’s where credit cards come into play.

One of the biggest factors in how credit scores are calculated is called your credit utilization ratio. It only applies to revolving accounts, such as credit cards and lines of credit, which don’t have a fixed term. Credit utilization isn’t measured for installment loans, such as mortgages and car loans, because they do have a set ending or maturity date.Credit utilization is a simple formula that equals your total account balance divided by your total credit limit. For example, if you have a credit card with a balance of $1,000 and a credit limit of $2,000, your utilization ratio is 50% ($1,000 / $2,000 = 0.50).

Keeping a low utilization, such as below 20%, is optimal for good credit.

Keeping a low utilization, such as below 20%, is optimal for good credit. So, by paying down your balance on the card to $400, you could reduce your utilization ratio to 20% ($400 / $2,000 = 0.20) and boost your credit scores.

A low utilization ratio says that you’re using credit responsibly. A high ratio indicates that you may be maxed out and even getting close to missing a payment.

Many people mistakenly believe that getting rid of their credit cards will automatically improve their credit. The surprising truth is that canceling credit cards usually hurts it because your available credit on the card plunges to zero, which instantly increases your utilization and causes your credit scores to drop right away.

However, whether closing a card is right for you really depends on your current and future financial situation. Use the following do and don’ts to know when ditching a card is best and how to do it with minimal damage to your credit.

RELATED: 5 Ways to Get a Loan With Bad Credit

10 dos and don’ts for when to cancel a credit card

1. Do cancel credit cards that are a net loss

If you’re like Maria and have great credit with an unused card that’s costing you money, you may want to consider canceling it. Many rewards cards come with an annual fee, especially when they offer cashback, airline miles, or points for merchandise. In some cases, using the rewards easily offsets the annual fee.

If you won’t use the card or can’t afford the annual fee, common sense should be the deciding factor, not your credit score.

However, if you won’t use the card or can’t afford the annual fee, common sense should be the deciding factor, not your credit score. However, one option is to replace a card that charges an annual fee with another card that doesn’t, ideally before you cancel the first one. That allows you to swap out one credit limit for another one and avoid any damage to your credit.  

2. Do cancel credit cards that tempt you to overspend

I also don’t recommend keeping a credit card if it tempts you to overspend. Taking a temporary hit to your credit might be worth it to prevent bigger problems in your financial life.

3. Do cancel credit cards to simplify your financial life

If you’ve missed payments or can’t keep up with transactions because you have too many cards, it might be worth it to strategically cancel one or more credit cards. Keep reading for tips to minimize the potential damage to your credit.

4. Do cancel credit cards with low credit limits first

If you cancel a credit card, choosing one with a higher credit limit poses more of a threat than getting rid of one with a smaller limit. The lower your credit limit on a card, the less closing it could negatively affect your credit.

As I previously mentioned, for optimal credit, it’s best to never carry a balance that exceeds 20% of your available credit limit. If you’re not sure what your credit limits are, you can review them by getting a free copy of your credit report at annualcreditreport.com.

5. Do cancel credit cards you recently opened by mistake

A common credit dilemma is what to do after opening a new credit card that you felt pressured into at a retail store. Sales clerks make getting a huge discount with a new card signup sound too good to pass up. In some cases, you may not even realize that what you’re signing up for is a credit card.

If you’re loyal to a store and make frequent purchases there, having its branded credit card can give you nice savings and promotional benefits that make it worthwhile. While you can’t erase the card from your credit history, if you decide that you’d rather not have the account, closing it sooner rather than later is better for your credit.

Free Resource: Credit Score Survival Kit – a video tutorial, e-book, and audiobook to help build credit fast!

6. Don’t cancel your only credit card

In addition to maintaining low credit utilization, the health of your credit depends on having a mix of credit accounts. That shows you can handle different types of credit, such as installment loans and revolving accounts. But if you cancel your only credit card, that would leave you deficient in the revolving credit category.

It’s better to spread out your balances on multiple cards and maintain low utilization on each of them, rather than have one card that you charge to the limit.

Therefore, I don’t recommend canceling a credit card if it’s your only one. Having at least one card in the mix rounds out your credit file. Ideally, you would have a total of two or three cards that come from different issuers, such as Visa, Mastercard, American Express, or Discover.

If you have more than one line of credit or credit card, most credit scoring models calculate your utilization ratio for each account and collectively on all your accounts. So, it’s better to spread out your balances on multiple cards and maintain low utilization on each of them, rather than have one card that you charge to the limit.  

Depending on the types of charges you make, you may need a low-rate card for times when you must carry a balance and a higher-rate rewards card for charges that you always pay off each month. No annual fee cards are best, but as I previously mentioned, rewards cards that come with a fee may be worth it.

 

7. Don’t cancel credit cards you’ve had for a long time

As if credit utilization and having a mix of credit accounts weren’t enough, a canceled credit card hurts your credit in other ways. Another factor that’s used in calculating credit scores is how long you’ve had credit accounts.

Having a long, rich credit history boosts your scores and makes you appear less risky to potential lenders and merchants. Canceling a long-standing credit card causes your average age of credit history to decrease, which hurts your credit. So, value credit cards that you’ve had for a long time more than those you’ve recently opened.

8. Don’t cancel multiple cards at the same time

If you have more than one credit card that you want to cancel, don’t shut them all down at the exact same time. It’s better to space out cancellations over time, such as one every six months, to minimize the damage to your credit health.

9. Don’t cancel credit cards if you’re planning to make a big purchase

If you’re planning to finance a big purchase, such as a home or vehicle, in the next three to six months, it’s not wise to cancel any credit cards. If your utilization rate increases and your credit scores suddenly take a dive during the application process, you may ruin your chances of getting a low-interest loan.

If you’re planning to finance a big purchase, such as a home or vehicle, in the next three to six months, it’s not wise to cancel any credit cards.

Maria didn't mention if she's looking to use her great credit to borrow money any time soon. But it's an important issue that I recommend she consider.

10. Don’t cancel credit cards because you’ve made late payments

Never cancel a credit card with negative information, such as late payments or being in collections, thinking that it will disappear from your credit file. All credit accounts stay on your credit report for seven years from the date you became delinquent, even after you or a card issuer closes it. Accounts with only positive information remain in your credit file longer, for up to 10 years

What should you do with unused credit cards?

If you or Maria go through these dos and don’ts and decide that it’s better not to cancel a credit card, use it occasionally to make small purchases that you pay off in full. That keeps it active and allows you to continue adding positive information to your credit history.

However, I don’t recommend keeping a credit card that you’re not using responsibly or that tempts you to overspend. Taking a temporary hit to your credit might be worth it to prevent bigger problems in your financial life.

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When you're ready to buy a home, choosing the best lender and type of mortgage can seem daunting because there are many choices. Since no two real estate transactions or home buyers are alike, it's essential to get familiar with different mortgage products and programs. 

Let's take a look at the two main types of mortgages and several popular home loan programs. Choosing the right one for your situation is the key to buying a home you can afford. 

What is a mortgage?

First, here's a quick mortgage explainer. A mortgage is a loan used to buy real estate, such as a new or existing primary residence or vacation home. It states that your property is collateral for the debt, and if you don't make timely payments, the lender can take back the property to recover their losses.

In general, a mortgage doesn't pay for 100% of a home's purchase price.

In general, a mortgage doesn't pay for 100% of a home's purchase price. You typically must make a down payment, which could range from 3% to 10% or more, depending on the type of loan you qualify for. 

For example, if you agree to pay $300,000 for a home and have $15,000 to put down, you need a mortgage for the difference, or $285,000 ($300,000 – $15,000). In addition to a down payment, lenders charge a variety of processing fees that you either pay upfront or roll into your loan, which increases your debt.

At your real estate closing, the lender wires funds to the closing agent or attorney. After you sign a stack of mortgage and closing documents, your down payment and mortgage money go to the seller and various parties, such as a real estate broker, title company, inspector, surveyor, and insurance company. You leave the closing as a proud new homeowner and begin making mortgage payments the next month.

What is a fixed-rate mortgage?

The structure of your loan and payments depends on whether your interest rate is fixed or adjustable. So, understanding how these two main types of mortgage products work is essential.

A fixed-rate mortgage has an interest rate that never changes, no matter what happens in the economy.

A fixed-rate mortgage has an interest rate that never changes, no matter what happens in the economy. The most common fixed-rate mortgage terms are 15- and 30-years. But you can also find 10-, 20-, 40-, and even 50-year fixed-rate mortgages.

Getting a shorter mortgage means you pay it off faster and at a lower interest rate than with a longer-term option. For example, as of December 2020, the going rate for a 15-year fixed mortgage is 2.4%, and a 30-year is 2.8% APR. 

The downside is that shorter loans come with higher monthly payments. Many people opt for longer mortgages to pay as little as possible each month and make their home more affordable.

Here are some situations when getting a fixed-rate mortgage makes sense:

  • You see low or rising interest rates. Locking in a low rate for the life of your mortgage protects you against inflation. 
  • You want financial stability. Having the same mortgage payment for decades allows you to easily budget and avoid financial surprises. 
  • You don't plan to move for a while. Keeping a fixed-rate mortgage over the long term gives you the potential to save the most in interest, especially if interest rates go up.

What is an adjustable-rate mortgage (ARM)?

The second primary type of home loan is an adjustable-rate mortgage or ARM. Your interest rate and monthly payment can go up or down according to predetermined terms based on a financial index, such as the T-bill rate or LIBOR

Most ARMs are a hybrid of a fixed and adjustable product. They begin with a fixed-rate period and convert to an adjustable rate later on. The first number in the name of an ARM product is how many years are fixed for the introductory rate, and the second number is how often the rate could change after that.

For instance, a 5/1 ARM gives you five years with a fixed rate and then can adjust, or reset, every year starting in the sixth year. A 3/1 ARM has a fixed rate for three years with a potential rate adjustment every year, beginning in the fourth year.

When shopping for an ARM, be sure you understand how often the rate could change and how high your payments could go.

ARMs are typically 30-year products, but they can be shorter. With a 5/6 ARM, you pay the same rate for the first five years. Then the rate could change every six months for the remaining 25 years.

ARMs come with built-in caps for how much the interest rate can climb from one adjustment period to the next and the potential increase over the loan's life. When shopping for an ARM, be sure you understand how often the rate could change and how high your payments could go. In other words, you should be comfortable with the worst-case ARM scenario before getting one.

In general, the introductory interest rate for a 30-year ARM is lower than a 30-year fixed mortgage. But that hasn't been the case recently because rates are at historic lows. The idea is that rates are so low they likely have nowhere to go but up, making an ARM less attractive. 

I mentioned that the going rate for a 30-year fixed mortgage is 2.8%. Compare that to a 30-year 5/6 ARM, which is also 2.8% APR. When ARM rates are the same or higher than fixed rates, they don't give borrowers any upsides for taking a risk that their payment could increase. 

ARM lenders aren't making them attractive because they know once your introductory rate ends, you could refinance to a lower-rate fixed mortgage and they'd lose your business after just a few years. They could end up losing money if you haven't paid enough in fees and interest to offset their cost of issuing the loan.

Unless you believe that rates can drop further (or until ARM rates are low enough to offer borrowers significant savings), they aren't a wise choice in the near term.

So, unless you believe that rates can drop further or until ARM rates are low enough to offer borrowers significant savings, they aren't a wise choice in the near term. However, always discuss your mortgage options with potential lenders, so you evaluate them in light of current economic conditions.

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5 types of home loan programs 

Now that you understand the fundamental differences between fixed- and adjustable-rate mortgages, here are five loan programs you may qualify for.

1. Conventional loans

Conventional loans are the most common type of mortgage. They're also known as a "conforming loan" when they conform to standards set by Fannie Mae and Freddie Mac. These federally-backed companies buy and guarantee mortgages issued through lenders in the secondary mortgage market. Lenders sell mortgages to Fannie and Freddie so they can continuously supply new borrowers with mortgage funds. 

Conventional loans are popular because most lenders—including mortgage companies, banks, and credit unions—offer them. Borrowers can pay as little as 3% down; however, paying 20% eliminates the requirement to pay an additional monthly private mortgage insurance (PMI) premium.

2. FHA loans

FHA or Federal Housing Administration loans come with lenient underwriting standards, making homeownership a reality for more Americans. Borrowers need a 3.5% down payment and can have lower credit scores and income than with a conventional loan. 

3. VA loans

VA or Veterans Administration loans give those with eligible military service a zero-down loan with no monthly private mortgage insurance required. 

4. USDA loans

The USDA or U.S. Department of Agriculture gives loans to buyers who plan to live in rural and suburban areas. Borrowers who meet certain income limits can get zero-down payments and low-rate mortgage insurance premiums.

5. Jumbo loans

Jumbo loans are higher mortgage amounts than what's allowed by Fannie Mae and Freddie Mac, so they're also known as non-conforming loans. In general, they exceed approximately $500,000 in most areas.

Always compare multiple loan products and get quotes from several lenders before committing to your next home loan.

This isn't a complete list of all the loan programs you may qualify for, so be sure to ask potential lenders for recommendations. Remember that just because you're eligible for a program, such as a VA loan, that doesn't necessarily mean it's the best option. Always compare multiple loan products and get quotes from several lenders before committing to your next home loan.

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