Common sense would tell us that if we have fewer outstanding credit cards, we are likely to be in better financial shape. Unfortunately, credit card companies and other lenders don't see it this way. Cancelling a paid off credit card can actually hurt your credit rating. Your credit rating is used by banks and lenders to estimate how likely you are to pay your loans on time for the complete terms of the loan. Based on this estimation, they assign you an interest rate that reflects the level of risk that they feel they are taking on by giving you a loan or a credit line. The worse your credit score, the higher the interest rate. If your credit score is too bad, you may have trouble getting a loan at all.

So how can closing a credit card make you a worse credit risk? One of the measures banks look at to assess your creditworthiness is your ratio of borrowed money to available credit. In other words, if you have three credit cards and each one has a total credit line of $5000, you have a $15,000 line of available credit. If you owe $2000 on one credit card, and $1000 on another, and zero on the third card, then you have an outstanding balance of $3000 against that $15,000 line of credit. That's 20% of your available credit. Now, though, if you cancel the paid off card, your available credit drops to $10,000 and the balance jumps to 30% of your total available credit.

Lenders look at this percentage to see how well you are living within your means. The higher the percentage, they feel, the more likely you are to dig yourself into a financial hole and be unable to repay the debt. So by cancelling a paid off credit card, lenders see you as less able to find money to pay them and will judge you to be a higher risk, consequently charging you a higher rate on any new loans or credit cards. Sometimes, even your existing credit cards will increase your interest rate if your credit rating falls.

The old rule of thumb used to be that you should keep the percentage of money owed to less than 30% of your available credit line. However, with the tight credit markets, many experts are suggesting that 10% or less is needed for a top credit rating. In any case, cancelling your paid off card can hurt your credit rating and make it harder for you to get good terms on a car loan or a mortgage. Cut up the card if necessary in order to stop yourself from overcharging, but don't cancel the account if you expect you'll need to borrow money in the near future. Keeping the best possible credit rating means lower interest rates and its one more step to help escape the credit card trap.

Author: Brad Sylvester