Secured credit cards enable virtually everyone to build (or rebuild) their credit by responsibly managing their secured credit card just like any other credit card. Best of all, many secured cards have low deposit requirements, and some even have a cash-back reward program similar to popular unsecured rewards cards.
Filling out an application for a secured credit card will put you on the fast track toward an excellent credit score, but here are a few things you should know before jumping in head first.
How a secured credit card works
The only difference between a secured credit card and a traditional unsecured credit card is that secured cards require collateral, typically in the form of a cash deposit. Typically, secured credit cards require that you deposit an amount equal to your credit limit.
Thus, to obtain a secured card with a $300 credit limit, you'll be required to make a $300 deposit. A $500 credit line would require a $500 deposit, and so on. A handful of secured credit cards allow for partial security, thus enabling a cardholder to secure a $500 credit limit by depositing $250, for example. The amount you have to deposit varies by card and your creditworthiness (credit score and income), but some allow for deposits as low as $49. (See our picks of the best secured credit cards at Fool.com.)
The deposit acts as a safety net for the bank. If you fail to repay your card balance, the bank will simply use your deposit to pay off the balance. However, you shouldn't look at the deposit as a "Get Out of Jail Free" card. Failing to make payments on a secured card will result in late payment fees, penalty charges, and negative marks on your credit report, just as any unsecured credit card would.
Why secured cards exist
It may seem silly to give a bank money so that they can loan it back to you, but there are many reasons why people open secured credit cards.
- Almost anyone can qualify. The deposit significantly reduces the risk that a bank will be left holding the bag if a borrower cannot repay. For this reason, banks are willing and able to issue a secured card to just about anyone, even those who have little income or very subprime credit scores. While bad credit histories and recent bankruptcies are likely to result in a denied unsecured credit card application, they're less likely to affect an application for a secured credit card.
- They can help you build credit. Secured credit cards typically report your payment history and other factors about your account to the credit bureaus as if it were a standard unsecured credit card. For this reason, a secured card can be a really good way to build credit for people who cannot get approved for an unsecured card. Secured credit cards are often the only truly free ways to build a credit score. In contrast, so-called "credit builder loans" offered by community banks and credit unions can be costly.
- They build a path to unsecured credit. Many secured cards eventually convert to unsecured cards after a certain amount of time, typically one to two years. At that point, the bank has sufficient payment history to see that the cardholder is capable of paying their bills on time, and will convert the card to an unsecured card by sending the deposit back to the cardholder. That said, building up your credit score with a secured card should allow you to open unsecured cards in the future, even if your secured card issuer does not have a "graduation" program through which a secured card can be converted into an unsecured credit card. After getting an unsecured card, it may make sense to ditch your secured card.
- Secured cards are credit cards. Some purchases require a credit card, or are easier to make with a credit card than with cash or debit. Hotels, car rental companies, and other merchants typically prefer their customers to pay with a credit card. Secured credit cards also have all the increased fraud protection that unsecured credit cards do.
Features of the best secured credit cards
When shopping around for a secured credit card, there are three features that you should prioritize.
1. Low (or no) annual fee
Traditional unsecured credit cards are very profitable for banks because they have high interest rates that can be charged on big balances on high credit limit cards. In contrast, unsecured cards typically have smaller credit lines and thus simply aren't that profitable for banks.
For this reason, the vast majority of secured cards carry an annual fee, or a charge you pay each year just to have an account. (None of Fool.com's top secured card picks have an annual fee, a rarity in the industry.)
2. Low initial deposits
Ideally, a secured credit card should allow you to make a deposit equal to a fraction of your credit line -- a $100 deposit for a $500 credit line, for example. Deposit requirements are typically a function of the borrowers' credit score and income. The better your score, the lower deposit you'll have to make.
Our top picks in secured cards feature two different deposit programs. One requires deposits equal to your credit line, with the ability to increase your credit line by making a larger deposit. The other offers some borrowers the ability to secure a $200 credit line with a deposit of $49, $99, or $200, depending on their creditworthiness.
3. Credit bureau reporting
It makes little sense to open a secured credit card account if it doesn't report your good payment history to the three credit bureaus. Some cards only report to one or two of the three major credit bureaus, which can result in some problems if lenders pull your score from the one bureau that your secured card doesn't report to.
We made this a priority in our rankings of the best secured cards, all of which report to all three major credit bureaus, thus giving cardholders the ability to bolster all three of their credit reports at the same time.
How to build credit with a secured credit card
The key to maximizing the benefits of a secured credit card comes down to knowing how the credit scoring system works. To maximize your benefit, and minimize expenses, there are really just three things you should know.
First, do not let your balance exceed 30% of your credit limit at any given time. After payment history, the second most important factor that goes into your credit score is your credit utilization, or your credit balances as a percentage of your credit limits. A credit utilization ratio greater than 30% ($300 of balances on a card with a $1,000 limit) will result in a lower score. If it means you have to pay your credit card every other week vs. once per month, it's worth it to maximize the benefit of having a low credit utilization ratio. Charge a tank of gas to the card each month, and pay it in full when the statement arrives. Boom. You're on your way to excellent credit.
Second, pay your balances on time and in full each month to avoid the accumulation of interest and fees. All you have to do is pay the "statement balance" reported on your statement by the due date and you'll never incur a dime of interest or finance charges. It's really that simple. Contrary to popular belief, carrying a balance and paying interest does not result in a higher credit score.
Finally, you should get started sooner rather than later. A good credit score can impact everything from the rates you pay to finance a car or home, the premiums you pay for insurance, as well as your ability to get a job. Yes, employers increasingly perform credit checks on job applicants. If you have bad credit, or no credit, applying for a secured credit card is a great way to start building up your report. Building or rebuilding credit isn't some overnight project; it's something that is done over the course of months or years.
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