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If you have bad credit or no credit history, the way to improve your credit score is to get credit and use it responsibly. But how can you get credit without a good credit score? A secured credit card can offer a way out of this Catch-22. This type of credit card requires a refundable security deposit that will serve as collateral on the account, which reduces credit card issuer's risk so you're more likely to be approved for the card.
Is a secured credit card right for you? Keep reading to find out how a secured credit card can help you build (or rebuild) your credit.
What Is the Difference Between Secured and Unsecured Credit Cards?
Most credit cards are unsecured. Instead of requiring collateral in the form of a deposit, the issuer looks at your credit history and credit score to see if you're creditworthy. If you are, they issue the card.
If you have poor credit or a thin credit file (that is, little or no credit history), credit card issuers know that issuing you credit could be risky. That's where secured credit cards come in.
To open a secured credit card account, you'll have to put down a refundable security deposit. Typically, the amount of the security deposit will determine your credit limit (although some card issuers will offer a higher credit limit than your deposit). If you default on your credit card bill, the card issuer can use your deposit to pay off the balance. If you cancel your secured card or convert it to an unsecured card later on, you'll get your security deposit back as long as you've paid off your balance.
Aside from the security deposit, a secured credit card works just like any other credit card. You can use it in the same places that accept unsecured credit cards, and no one will know that it's secured.
Do Secured Credit Cards Build Credit?
If you're trying to rebuild your credit or have minimal credit history and need to build your credit, you've got a couple of options for doing so.
You may be able to become an authorized user on someone else's credit card account or have someone with good credit cosign on a credit card account for you. Parents often use these options to help their teens or college students establish credit. If you have bad credit, however, it may be hard to find someone willing to assume responsibility for your credit card charges.
You can also apply for a credit card tailored to people who have bad credit or a limited credit history. These are known as "subprime" credit cards. Unfortunately, unsecured cards offered to borrowers with poor credit often charge very high interest rates and fees.
Secured credit cards may offer a better alternative. These cards, specifically designed to help people build credit, have many advantages:
- You can get approved even with bad credit. Card issuers will still check your credit history, but it's much easier to get approved for a secured card over getting an unsecured card. Because the security deposit eliminates risk for the credit card issuer, secured cards have much more lenient credit score requirements. Some secured credit cards don't even have a minimum credit score requirement.
- Secured cards can help build credit. At first glance, a secured credit card may seem similar to a debit card or a prepaid card. The key difference is that debit cards and prepaid cards don't report your payments to credit bureaus. As a result, using debit and prepaid cards won't help you build a credit history. As long as the secured credit card you're considering reports your payments to at least one of the three major consumer credit bureaus (Experian, TransUnion and Equifax), making on-time payments will help to improve your credit score.
- A secured card can be a stepping stone to an unsecured card. Many secured credit card issuers will convert your card to an unsecured card after you've demonstrated 12 months of on-time payments and improved your credit score. In some cases, you may need to request your card be converted, while other issuers will do it automatically. If your secured card doesn't offer this option, you can still apply for an unsecured credit card once your credit score is good enough. (You should regularly check your Experian credit report and credit score for free to see how they're improving.)
- Some secured cards offer valuable benefits. Credit cards offer benefits and fraud protection you won't get with cash or even a debit card. Some secured cards even offer benefits such as travel insurance, rental car insurance, damage or theft protection and extended warranty coverage. You can find secured credit cards, such as the Discover it® Secured, that offer cash back on purchases. Many secured credit cards include free credit monitoring—a very useful benefit if you're trying to build your credit.
On the downside, secured credit cards often charge higher interest rates than unsecured credit cards, and many also charge fees. Credit limits are typically low, so you won't have the spending power you might have with a traditional credit card.
Fees and high interest rates aren't ideal, but if you have a limited credit history or a low credit score, a secured credit card is often your best choice. Think of a secured credit card as training wheels: By learning to manage a secured card responsibly, you can eventually move up to an unsecured credit card that offers better terms and a higher credit limit.
How to Get a Secured Credit Card
1. Rates and Fees
Secured credit cards tend to charge higher interest rates and fees than standard, unsecured cards, so review the card's annual percentage rate (APR), annual fee and any miscellaneous fees carefully. Pay special attention to the card's annual fee; some secured cards don't have one, but others have high fees, which may be billed monthly. In addition to the annual fee, see if there are any application fees, maintenance fees, processing fees or additional cardholder fees. Also, make sure the card has a grace period. You can avoid interest charges by paying your monthly statement balance in full before the grace period ends.
Where do you find all this information? Every credit card issuer is required to print its card rates and fees in a standard format known as a Schumer box. Here's an example of a Schumer box:
You may need to hunt around a bit to uncover the Schumer box on a credit card's website; you can usually find it by clicking on links such as "rates and fees" or "terms and conditions."
2. Cardholder Benefits
Compare the benefits various secured cards offer. A card's benefits aren't as important as its APR and fees, but if all else is equal, the card with better benefits is usually the better choice. For instance, if you travel often and plan to use your secured card to rent a car, benefits including rental car insurance or travel coverage would be helpful. If you plan to use your secured credit card to make a major purchase such as a new TV or computer, look for a card that offers extended warranty coverage and protection against accidental damage or theft for purchases.
3. Additional Options
When you apply for a secured card, look for a card issuer that also issues traditional, unsecured credit cards. This will make it easier to transition to an unsecured card when you're ready to do so. Also, find out the criteria for getting an unsecured card. Some card issuers will approve you for an unsecured card after 12 months of on-time payments.
4. Deposit Requirements
The deposit amount on a secured card varies, but many secured cards require a minimum deposit of $200 and allow you to make a deposit of up to $2,000. Be sure you have the deposit ready and available to transfer as soon as you're approved; you'll need to do this to activate your new credit card. The credit card issuer keeps the deposit until you either close the account in good standing or transition to an unsecured card.
It's a good idea to make sure your deposit will be held safely. It should be kept in a separate account at an FDIC-insured institution. Some card issuers may even put your funds in a certificate of deposit (CD) so your money will earn a little bit of interest.
Survey your options for increasing your secured card's credit limit. For example, do you have to demonstrate on-time payments for a certain period before you can request a credit increase? If you're starting out with a very low credit limit, such as $200, it's helpful to know when you'll be able to increase the deposit on your secured card and in turn increase your credit limit.
5. Credit Reporting
To make sure the card you're considering will actually help build your credit history, find out if the issuer reports your payments to at least one (and preferably all) of the three major consumer credit bureaus. If a card doesn't report your payment history to the credit bureaus, using it won't help you improve your credit scores. Many secured cards will promote the fact that they report to credit bureaus. If the one you're considering doesn't specify whether it reports to the bureaus, contact the card issuer to find out.
How to Use a Secured Credit Card
You've got your secured credit card in hand. Now what? You can use your secured card just as you would any credit card. As with any credit card, you'll get a statement each month. Make sure you have the funds available to make at least your minimum payment every month. Ideally, you'll completely pay off your balance every month.
You might be tempted to max out your new card on a big purchase. But before you hand over your card for that new TV, remember that the goal of your secured card is to help you build credit. To do that, use your card a few times each month to make small purchases, and always pay your bill on time. Limiting your purchases helps make sure you can cover your monthly payments. If possible, consider setting up auto payments to help make sure you don't miss a payment. Your history of on-time payments is the biggest factor in your credit scores, so staying consistent will gradually build your credit history and help to improve your credit scores.
You can carry a balance on your secured credit card, just like with any credit card, but doing so will incur interest charges. Another risk of carrying a balance is that it increases your credit utilization ratio, which is the percentage of your available credit you're using. A high credit utilization ratio (above 30%) can hurt your credit score. Finally, if your balance gets so big that you can't pay your bill, you'll eventually lose your security deposit. Paying off your balance in full each month helps to demonstrate that you're managing your credit responsibly.
To monitor your progress, keep an eye on your credit scores. Some secured card issuers will automatically approve you for an unsecured credit card as soon as you've made a certain number of on-time payments on your secured card. Others require you to apply. If your credit score climbs high enough, you may even be able to apply for an unsecured credit card through another issuer.
The Secured Card Solution
If you have poor credit or no credit history, a secured credit card can offer an affordable way to build or rebuild your credit. With a credit card in hand, you can enjoy cardholder benefits, security and convenience features as well as more flexibility in making purchases.
Before applying for a secured credit card, check your credit report and credit scores to see which cards are within your reach. Then research your options, comparing each card's terms and conditions, to see which secured credit card best fits your needs.