This is a vicious circle: you need to build strong credit to demonstrate healthy financial behavior, but many lenders are not willing to lend you money until you don’t have a good credit score. But don’t worry! There are several ways to start credit and build a strong one over time. Secured credit cards are one of the possible options. Let’s find out how they work.
What Is a Secured Credit Card?
A secured credit card refers to a credit line that requires a security deposit. This means that you need to deposit a certain amount before you can use it. This amount typically equals your credit limit. Thus, if you make a $500 deposit, it will be the limit available for you to make purchases. However, your deposit is not used for your monthly payments as it is for prepaid cards (see the difference below).
Some credit card issuers allow you to upgrade your secured card to an unsecured one for accounts in good standing (meaning they manage to pay on schedule over some time). This way, you will get your deposit back. If you fail to pay timely, a lender withdraws your payment amount from your security deposit.
As secured credit cards have a repayment guarantee, they don’t carry risks to lenders. That is why they are available to borrowers with bad or no credit.
How Do Secured Credit Cards Work?
Everything starts with an application. You need to fill out a form and specify your personal and financial information. Then, an issuer checks whether you meet its requirements and make an approval decision. After you get approved, you need to make a security deposit. After all, you can use your card to pay for any purchases or regular expenses within your credit limit.
Each time you use your secured card, you initiate debt. The amount you spend needs to be returned within the agreed-upon terms. Interest rates may be applied immediately or after a promotional period, depending on the lender. Your credit card payments will be reported to major credit bureaus. If you pay timely, a lender may upgrade your card to an unsecured one. This way, you will get your security deposit back. Then, you will be able to get a higher credit limit.
Secured Credit Cards vs. Unsecured Credit Cards
While secured cards require a security deposit, unsecured ones are not secured by any asset. Thus, they pose more risk to an issuer. To offset the risk, an issuer sets a minimum credit score requirement and makes a hard credit history check for each request. Thus, unsecured credit cards are harder to get if you have bad or no credit. Even if you will be able to, you will be offered extremely high interest rates.
However, unsecured credit cards have higher limits, so you can afford more. You also don’t risk losing your deposit in case of late payments. However, paying late will affect your credit score, making it go down.
Secured Cards vs. Prepaid Cards
Unlike secured cards, prepaid cards won’t help you build credit. They are just plastic that requires you to deposit money into a linked account. The amount you deposit will be used toward your further purchases. Simply put, it’s a non-refundable deposit. You just use your own money in a digital form to pay for your purchases. As it’s not considered borrowing, the issuer doesn’t report your account activity to credit bureaus.
How to Use a Secured Card to Build Credit?
Here are some ways to use a secured credit card to boost your credit:
- Keep your credit utilization low. Make just a couple of small purchases each month and keep track of your balance. It shouldn’t exceed 30% of your available credit limit;
- Try to pay before the due date. By paying early, you can show that you’re a reliable borrower who takes debt seriously. This will also help you avoid late payments;
- Set up payment alerts. This way, you won’t miss the due date. You can also set up an automatic payment, which means the money will be automatically deducted from your bank account on the set date and transferred to an issuer;
- Pay more than the minimum payment. This will help you avoid higher interest and fees and demonstrate your solvency.