There’s a conundrum when it comes to credit: It takes credit to build credit. Those with good scores have ready access to instruments to further improve their standing. Meanwhile, those with little or negative credit have far less access to the very credit which is required to build it.
But those with little or no credit don’t need to fall prey to high-fee, high-interest options that make building or rebuilding credit extremely expensive. A secured credit card can be a useful tool for establishing — or reestablishing — a positive credit history. And a positive credit history is the basis for obtaining further favorable credit.
How Does a Secured Credit Card Work?
Companies offer secured credit cards as an alternative to traditional ones. Getting one requires a security deposit, which protects the financial institutions risk that the consumer might not pay his or her bill.
But aside from providing a security deposit, getting a secured credit card isn’t very different than getting an unsecured one.
In most cases, your security deposit is your credit limit. If you provide a $200 security deposit, you’ll get a $200 credit limit. If you provide a $500 security deposit, you’ll get a $500 credit limit. You must typically provide security of at least $200 to open an account.
The issuing institution holds your deposit as collateral. It issues you a card, which works exactly like a typical, unsecured credit card. You make purchases, you get billed, you pay the bill. Repeat. Business as usual.
That is, unless you fail to pay the bill. Then the financial institution has the right to take your collateral and close your account.
A secured credit card is easy to get, and it provides an option for those with little or negative credit history to establish a positive one, which is the prerequisite to obtaining credit on favorable terms.
Secured vs. Prepaid Credit Cards
The difference between secured credit cards and prepaid ones is night and day. They’re completely different.
A prepaid card is issued in an amount that you purchase the card for. You then use your own money to make purchases.
With a prepaid card, no credit is extended. You’re using your own money. This is a fundamental and monumental difference.
When you use a secured card, you make purchases using the financial institution's money. They’re extending you credit, albeit restricted to the amount of your credit limit. With a prepaid card, there is no credit being extended. Hence there is nothing to report to a credit agency. Prepaid cards don’t build or establish credit because there is no credit involved.
Secured Credit Cards vs. Those for People With “Bad Credit”
Some institutions issue cards to consumers whose credit scores are very poor. From the issuer’s perspective, the difference between a secured credit card and an unsecured card for consumers with bad credit is how the issuer is managing risk.
With a secured card, the issuer limits risk by requiring collateral, typically in the amount of the credit limit. With cards for consumers with bad credit, the issuers don’t have security, so they make up for the relatively higher risk of default by charging more in fees and interest. They know that they’ll have more consumers defaulting, so they need to collect excess from those who pay.
The difference from a consumer’s perspective is that you can generally find more favorable terms — lower fees and lower interest rates — with secured cards than with unsecured ones for low-credit consumers. With secured cards, consumers have the risk of losing their deposit. In exchange, they often have lower costs.
How to Use a Secured Card to Rebuild Credit
The largest factor in credit scoring is payment history. In order to have a payment history, you must make payments. Obviously. You need to use the card and make a payment by each due date.
The second largest factor in credit scoring is credit utilization. Your credit utilization ratio is the ratio of used credit to available credit. It’s simply the amount you owe divided by your total credit limit. This appears to be in conflict with building your payment history:
You need to use the card to build a payment history, but not use it to keep your utilization low. The key is in how you use it.
In order to build a positive credit score as rapidly as possible, you should use the card regularly, but only for a small amount. You want to have a bill every payment cycle, but you want the outstanding balance to be small so that you have a good utilization ratio.
This is especially true with cards that have low limits. A $50 balance on a $1,000 limit is only five percent, but a $50 balance on a $200 limit is 25 percent. When you have a small credit limit, you should pay close attention to utilization, as it can change very quickly.
In the long run, positive use of a prepaid card leads to increased opportunities for credit. You can often get a credit limit increase from your issuer after demonstrating good credit management for a period of a year or so. Or you might even be able to obtain an unsecured card under reasonable terms at that point.
A secured credit card isn’t the best answer for everyone. Sometimes people who are just starting out can get an unsecured card with reasonable costs. Those who have damaged credit are more likely to need to go the secured route. But in all cases, you should compare options to make certain that you’re getting the most favorable terms available at that point in time.
A secured card can be a great way to re-enter the credit market. By using one responsibly across a period of time, you can reestablish a positive history and make yourself eligible for additional credit opportunities on favorable terms.
In the long run, this could lead to increased opportunities. The cost might be higher than that of a card for people with great credit, but sometimes there’s a cost to getting ahead. By carefully selecting the best option, you can move toward getting future credit on favorable terms.