Credit cards are a good tool for making the most of your money, but you need the right version of the tool to get the job done. A tool that sits in your toolbox doing nothing was a waste of money. And paying an annual fee on a credit card that you're not taking full advantage of is a waste, too.

If you're thinking of canceling a credit card because you don't think the annual fee is worth paying, first make sure you know how it will affect your credit score and how you can mitigate the costs of the annual fee.

Woman cutting up credit card with scissors.

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Canceling a credit card hurts your credit score in two different ways

There are several factors that go into calculating your credit score. Two of the biggest are your credit utilization ratio and your age of accounts.

Credit utilization is the percentage of available credit you actually use -- the lower the better.

Age of accounts is an average based on when you opened all of your credit accounts.

Credit mix -- holding several different types of credit -- also plays a small role and could be impacted by canceling a credit card.

When you cancel a credit card, you lose whatever available credit you had and diminish the average age of your accounts. As a result, you may very well see a decline in your credit score when canceling a credit card, especially if you've had the card for awhile.

But there are better options for most consumers.

If you spend too much using credit cards, do this before canceling

If you find yourself frequently succumbing to impulse purchases, buying things you can't afford, and racking up credit card bills you know you can't pay at the end of the month, you might want to cancel your card. You've finally paid off that debt, and you just want to be done with it.

That's fine. Be done with using that credit card. But that doesn't mean you have to cancel it.

If you can't control the impulse to spend when using a credit card, make the card unusable. Take it out of your wallet. Remove your card data from every online shopping site. Put a note on the card not to use it. Demagnetize it. Shred it to pieces if you need to.

Just because you have a credit account doesn't mean you have to use it. (Note: Some consumers have reported banks closing accounts for inactivity. That's a worst-case scenario, and it's something you should be OK with considering you don't use the card.)

Teach yourself to control your impulses. Track your expenses and set a budget. When you're ready to use a credit card, it'll be there waiting for you.

If there's an annual fee on the card, read on to see how to get rid of it.

When you call to cancel, consider what the credit card issuer offers

If your credit card has an annual fee you'd prefer not to pay, call in and ask to cancel your card. Remember, your account won't be closed until you give final approval.

When you ask to cancel the card, you'll likely be transferred to the retention department. Explain why you're canceling the card -- e.g., "I'm just not sure I'm getting enough benefits to justify the annual fee" -- and the retention department might offer you a bonus just for staying a cardmember. It could be a statement credit or bonus points. There may be a minimum spending requirement like with many sign-up bonuses, or the issuer may just credit your account when your next statement closes and you pay the annual fee.

The bonus points offered by retention can be more valuable than the annual fee. In fact, I've been offered bonus points for cards with no annual fee if I spent a certain amount in three months.

This method can have varying results from person to person and from credit card to credit card. If you don't get a retention offer that you think makes it worth paying the annual fee, there may still be another option.

Instead of canceling, "downgrade" your credit card

If there are no retention offers on your current credit card or you don't want to really use the card anymore, the best thing you can do is change the card to a no-annual-fee version. (Note: This isn't always an option; many co-branded hotel and airline credit cards don't have fee-free versions.)

Call up the issuer and ask to make a "product change" for your current credit card. Some issuers have rules regarding product changes that require you to stay in the same "family" of credit cards, so not every card from the issuer will be available to you. Just ask if you can change to a no-annual-fee card, and the representative should be able to provide you some information on which cards are eligible. If you've found a no-annual-fee card you like from the issuer, but the representative doesn't mention it, it doesn't hurt to ask about it.

For example, if you signed up for the Chase Sapphire Reserve, but you don't want to pay the $450 annual fee anymore, you can call and ask to product change to a no-annual-fee card that still earns Chase Ultimate Rewards points. Your no-fee options include the Chase Sapphire, Chase Freedom, and Chase Freedom Unlimited. Take the time to review your options and figure out which is best for you. 

An important caveat is American Express. It has charge cards and credit cards. Charge cards are a different breed of plastic, where you must pay off your bill at the end of the month. You cannot change from a credit card to a charge card or vice versa, so be sure to pay attention.

The great thing about changing to a no-annual-fee credit card is that it usually has no impact on your credit score. The credit limit and account age remain exactly the same.

Sometimes you just have to cancel the card

These strategies don't always work out the way you'd like. If you don't have any downgrade options and the retention offers just don't present enough value, there's no reason you should pay an annual fee just to protect your credit score.

Just make sure you do your due diligence and know all of your options before you move forward and cancel the card. It could save your credit score and save you some money at the same time.

Adam Levy has no position in any stocks mentioned. The Motley Fool recommends American Express. The Motley Fool has a disclosure policy.