Benefits of Eliminating Credit Card Debt

Canceling a credit card could actually hurt your credit score.

Canceling a credit card could actually hurt your credit score.

Credit card debt takes a big bite out of your wallet and, more importantly, tarnishes your financial image. A high unpaid credit card balance makes you a questionable client for loans and may even sabotage your efforts to to get a high profile new job because it can make you appear irresponsible to prospective new employers. Pay down your debt, but keep the cards to establish a track record of paying on time.

Debt Burden

Credit cards carry the highest interest rates in the industry, hands-down, and by a wide margin. For example, in April 2010, credit card interest rates were in the 12 to 14 percent range. By contrast, auto loans fluctuated between 6.5 and 7 percent, home equity loans were in the 5 to 7.5 percent range and fixed mortgage rates hovered between 4 and 5 percent, according to the information website OnlineEarnings.com. That means that $10,000 in credit card debt would cost you a whopping $1200 to $1,400 in interest payments over the course of a year. Paying off your credit cards is, of course, the best option, but if you can’t do that, consider converting your outstanding balance to another form of debt such as a signature loan from your credit union, or use a home equity line of credit to pay it off. Interest payments on the same amount in a home equity loan format could cost you as little as $500 in interest per year, a savings of up to $900.

Credit Score

Credit card debt is a key part of your overall credit rating, which matters big time when you’re trying to get a mortgage. Your credit score comes from a formula that takes into account your total credit line, how much of it you’re using, your history of on-time and late payments and how long you’ve had your various loans and credit cards. Also called a FICO score, your credit rating can range from 300 to 850. Numbers above 800 are unheard of; median scores are in the 720 to 725 range. Thirty percent of your credit score is based on the ratio of your total debt to your total credit line, according to Kiplinger.com. Eliminating credit card debt can drastically improve this ratio.

Impact

Credit card debt, as reflected in your credit score, also may affect your insurance rates, whether you get approval to rent an apartment and even whether a company decides to hire you. Banks, landlords and companies routinely run credit reports to find out if you’re a good credit risk. If your score looks questionable, they will either charge you a higher rate or decline to take you on as a customer. A prospective employer may look at your credit history to get a picture of how responsible and reliable you are. This is legal so long as the company informs you in advance.

Cancelling Credit Cards

You may be thinking that getting rid of one or more credit cards is a smart move, but, ironically, this can actually hurt your credit score. Here’s why. Banks look at the total amount of credit available to you and how much of it you’re using. This is called your credit utilization ratio. Say you have two credit cards and one has a credit limit of $7,000, the other has a limit of $8,000 and your combined balance on the two cards is $3,000. You have a total credit limit of $15,000 and you’re using 20 percent of it. If you cancel the card with the $7,000 line of credit, you’ll have a total credit line of $8,000 and you’ll be using $3,000 of it—a credit utilization ratio of 37.5 percent. Banks also look at how long you’ve had a particular line of credit because they want to see a long history of reliable payments, so be wary of canceling any cards you’ve had for a while. The best strategy is to work down the debt and then use the card, but pay it off in full each month to establish a good payment track record.

About the Author

A retired federal senior executive currently working as a management consultant and communications expert, Mary Bauer has written and edited for senior U.S. government audiences, including the White House, since 1984. She holds a Master of Arts in French from George Mason University and a Bachelor of Arts in English, French and international relations from Aquinas College.

Photo Credits

  • scissors and credit card cut in two image by Warren Millar from Fotolia.com