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When it comes to cash acceptance, making a purchase can be hit or miss. Credit cards have become essential in commerce, and not having one severely restricts spending options. That's why it has become necessary to have at least one credit card in your wallet for places where cash or other forms of payment may not be accepted.
However, obtaining a credit card isn't always easy. Those with no credit history or poor credit are less likely to be approved, as lenders seek assurance of timely payments. Credit card companies prefer applicants with excellent credit, stable employment, and a history of on-time payments.
For individuals struggling to qualify for a traditional "unsecured" credit card, there is an alternative to consider: secured cards. These cards are available to those looking to build or rebuild their credit. With a secured card, users can make payments and establish a pattern of responsible spending, helping them qualify for other forms of credit in the future, including unsecured credit cards.
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How is a secured credit card different from a regular credit card
When you apply for and are approved for a regular credit card, the credit card company is extending you a loan. The amount of your loan is known as your credit limit. You can make purchases against your credit limit. For example, if you have a limit of $500 and use $300, your new available credit will be $200, until such time that you pay back the $300 you used (with interest).
This loan is unlike other loans because you are offering nothing to the credit card company as collateral. When you buy a car or house for example, the car or house can be considered collateral against the loan. Unsecured credit cards have no such collateral. If a bank were to offer you a credit limit of $10,000, they are effectively giving you that much money on the good faith that you will pay it back. Your strong credit history is evidence (in lieu of collateral) that you are someone that will pay it back.
On the contrary, someone without strong credit or any credit (because they’ve never had a credit card before) could benefit from a secured credit card. This is a card that is backed by a deposit made to the credit card company by the borrower as a form of collateral. This deposit is typically equal to the credit limit and is usually not very much, maybe $500 or $1,000. This money belongs to the borrower and is only held by the credit card company. They will only touch your deposit, if the borrower defaults on the credit card agreement, and only then to recoup any losses incurred.
Aside from this deposit, which is held by the credit card company, the secured card is very similar to an unsecured card. Both cards can be used in the same way, both will be charged interest (the interest could be higher for a secured card) and borrowers should expect to pay monthly for charges incurred on the card.
Secured credit cards vs Prepaid Debit Cards
Some people might confuse a secured credit card for a prepaid debit card. While a secured credit card is essentially a credit card (with a deposit being held by the credit card company). A prepaid debit card is card that is linked to a bank account but does not help you build or establish credit. You can put money on the card and use it as you would a credit card to make purchases, but it has no impact on your credit score.
How a secured credit card works
A secured credit card works just like a regular credit card, except that a deposit was made to be held by the credit card company as collateral. The credit limit on a secured card is typically equal to that of the deposit.
With a secured credit card, you can expect to pay interest, it might even be higher, depending on the card issuer. You can expect to make monthly payments. Those payments need to be made on time and the amount paid should be at least equal to or greater than the minimum monthly payment.
With respect to the deposit, this money is yours and will be held by the credit card company. In the event you close the card or transition the card to an unsecured credit card, the deposit money will be refunded back to you. With a secured credit card you are still technically being given a loan, only your loan is backed by a deposit to help assure the credit card company will not be subject to a loss.
How a secured credit card can help build your FICO® credit score
Since secured cards are still in fact credit cards, activity is reported to the credit bureaus. When you have a secured card and you make regular monthly on-time payments, those payments are tracked and you begin to establish a pattern of behavior. Credit card companies like to see this type of behavior.
In addition to monitoring if you make your payments, credit bureaus also pay attention to your credit utilization. For example, if you have a card with a $1000 limit and keep an average balance of $500, your credit utilization would be 50%.
By monitoring this, credit card companies and other lenders are looking to see if you have a tendency to use all your credit, leaving little wiggle room should something unexpected occur. They prefer borrowers to have a credit utilization rate of 30%. That would mean keeping spending to $300 on a card with a credit limit of $1000.
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When can I get a regular credit card
If you apply for and receive a secured credit card and use this card regularly, making payments on-time and keeping your credit utilization rate within a reasonable amount; you can expect to start to see your credit score grow in about a year. The more time you demonstrate healthy credit habits (on-time payments, managing your spending, etc) the more your credit will grow. Once you can get your FICO® credit score to about 670 or more, which is considered a “good” credit score, you can ask your credit card company if they will transition your card to an unsecured card (what most people think of when thinking of credit cards). You can also apply for another card and cancel the secured card if you are able to receive an unsecured credit card from a different credit card company.
Keep in mind, once you build your credit up to good or even excellent, don’t squander this newfound financial freedom by applying for too many cards. Too many cards could negatively affect your score by having too much available credit.
Your FICO® credit score will stay high if you show responsibility and restraint. With a higher score you will also begin to be able to receive better rates and perks, as credit card companies typically compete for borrowers with excellent credit.
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