Ditching the Old Plastic

Got a lot of credit cards? Are there any you don't use? Maybe you got a store card to get a discount on a big shopping day. Or maybe you decided to take the prestigious platinum card when you got your first offer. Lots of us have cards that we opened for one specific purchase or to get through a long-past series of financial challenges. In the midst of financial spring cleaning, it can be tempting to just cancel them all in the name of simplicity, or in the hope of improving credit scores. But is that a good idea?

Not so simple

It seems like an easy solution. If, for example, you took out a store card from Home Depot while you were remodeling your home a few years back, it may have been sitting untouched in your wallet for a long time. Meanwhile, prestige cards like the platinum card from American Express charge annual fees that you may not want to pay anymore, especially if you can get a platinum Visa or MasterCard that charges no such fee.

It turns out that the case for canceling extra credit cards isn't as clear-cut as you'd think. Those unused cards in your drawer represent an emergency fund of sorts, ready-to-go loans that you can use instantly in times of crisis. While relying on high-interest credit cards isn't the best of rainy-day strategies, those old cards can be an essential lifeline if you exhaust your short-term savings during an emergency.

FICO follies

But what about your credit rating? Surprisingly (at least to me), eliminating credit cards doesn't usually help your credit score. It might actually hurt!

As fellow Fool Dayana Yochim noted a while back, once you have more than seven credit cards, your FICO credit score takes a hit -- and unfortunately, that hit doesn't immediately go away once you get back to fewer than seven. Even worse, if you carry a balance on other cards, canceling the unused cards can hurt your score, if your total balance then exceeds 30% of your total credit available. And canceling your oldest credit cards lowers the average age of your accounts, another credit score no-no.

The upside

On the other hand, if you're applying for a mortgage, closing extra cards can sometimes help -- some lenders get concerned if you have too many credit lines available, because of the possibility that you could go on a mad binge and not be able to pay your mortgage. Of course, there are other good reasons to close cards, including removing the temptation to overspend and streamlining your financial life. And if you have cards that charge annual fees, ditching those can be very tempting.

If you've considered the pros and cons and decided to close some accounts, here are some other things to think about:

• Don't close any card that still has a balance. It's common for credit card issuers to crank your interest rate up to the legal maximum once you've closed the account, since they no longer have any incentive to try to keep you and can position the charges as a "penalty." In fact, don't give the credit card company any hint you're thinking of leaving until you're actually ready to go -- and by "ready," I mean having no balance. Rolling your balances onto a lower-interest card is always worth doing, especially in this case.
• Beware the last-ditch sales pitch. While you can cancel some cards over the Web or via automated phone systems, others require you to talk to an actual human -- and if you've been a good customer, that human may hit you with a hard-sell pitch to try to keep your business. You may be offered a special lower rate, a waived annual fee, an upgrade to platinum status, extra frequent-flier miles, or any number of other benefits. But if the special deal still isn't better than the cards you've planned to keep, then don't give in to the sales pitch.
• Make sure the issuer notes that you asked to have it closed. The issuer's report to credit agencies should note that the account was closed at your request. Ask to make sure it's reported this way.
• Keep the confirmation. Shortly after you cancel, you should receive a written confirmation. Keep that confirmation in case you need to resolve any questions -- or correct your credit reports -- later.

To provide liquidity for emergencies, you should probably always have a cash reserve in a money market fund¹ or traditional savings account or CD, no matter what your life stage.

One last thought: Scary as it might seem, it's a good idea to review your credit reports every now and then. Each of the reporting agencies will provide you with a free copy once each year, and regular self-reviews are key to catching errors (which are all too common) before they hurt you. Check out the Fool's Credit Center for more details on reading and fixing your credit reports, and for more in-depth advice and assistance on getting your credit into shape, try out our Motley Fool Green Light newsletter free for 30 days.