Is it rational that agencies downgrade your credit rating if you close a card?

Question

Multiple sources say that if you have several credit cards with balances, and you pay down one of them, your credit rating will take a hit if you close that card. Now I know what the stated reason is -- credit agencies factor in the ratio of your total debt to your total available credit limit, so if you close out a zero-balance credit card, your ratio of total debt to total credit limit has gone up. However, I'm arguing that it doesn't make any rational sense for them to penalize you for that.

In some cases, if A and B have the same debt but B has a lower credit limit, it's rational to give B a lower credit score. If A has a $50,000 credit limit is usually $25,000 in debt, but B has a $30,000 credit limit and is usually $25,000 in debt, then it's likely that A has some degree self-control, while B doesn't stop spending until they almost "hit a wall".

However, that's not what we're comparing. Suppose you have a credit limit of $50,000, and you've just finished paying down your debts from $40,000 to $25,000. You have two cards with $10K limits that you just paid down, and you're trying to decide whether to leave them open (be like A), or close them (be like B). Ignoring the credit rating, the rational choice is to close them -- every additional card is an additional risk of identity theft, an additional relationship to manage, an additional source of temptation, and (sometimes) an additional annual fee. But the rating agency punishes you for doing the sensible thing here. And they penalize you even though they can see your history, so they know you're someone who is paying down your cards and closing them -- as opposed to someone who started with a $30K limit and then ran up their cards until they "hit the wall".

So it makes no sense to me that a person who has paid down part of their debts, and wants to reduce their risk and fees by closing a zero-balance credit card, would be penalized for this. Am I missing something, or is this just a counterproductive rule of the rating agencies that everyone accepts because "it just is"?

Answer 1

Generally, Credit ratings are automatically calculated from your current situation, and are not influenced by the sequence of actions that got you there.

You are right that a sensible action might get you (temporarily) in a situation that looks statically worse than before, but that is a minor side effect, and an automated credit rating calculation cannot easily account for that - so it doesn't.

A human might look at the sequence of actions an individual takes, and realize that there is an improvement process; but credit ratings are not given by human, they are calculated from statistical historical behavior data. Every single piece of a credit rating might or might not make sense for a specific person, but statistically, they are predicting average future payback behavior with some accuracy.

Answer 2

If A has a $50,000 credit limit is usually $25,000 in debt, but B has a $30,000 credit limit and is usually $25,000 in debt, then it's likely that A has some degree self-control, while B doesn't stop spending until they almost "hit a wall".

Credit rating agencies don't know your salary / income. The Credit limit is a rough indicator of the salary / income one has that can be serviced by individual; the assumption being lending institutions would have made some due diligence. So all things being equal; a person earning say 100K; A has credit limit of 50K and spend on 25K is better than B having a credit limit of 30K [implicitly assumed his salary is not 100K but less] and spending 25K.

Suppose you have a credit limit of $50,000, and you've just finished paying down your debts from $40,000 to $25,000

If you are saying someone was using revolving credit and has raked up 40K and not paid in full every month; the credit rating would already be hit badly. In such cases if a card is closed; it is not sure if this was initiated by Bank or by individual. It indicates a lack of self control.

Generally if you have multiple credit cards and are paying on time; if you close the card and this does not reduce your limit drastically; the score gets nominally impacted.