If you are among the millions of Americans whose credit isn't good, the credit cards you have to choose from are probably very limited. However, there is one type of card that far too few people know about -- the secured credit card.
When used correctly, a secured credit card can be very helpful in rebuilding your credit, while leaving more of your money in your pocket.
What is a secured card?
A secured credit card works just like a traditional credit card, except it requires you to put a security deposit into a bank account in order to receive the card. With most secured card programs, the amount of money you deposit will be equal to your initial credit limit.
Before you say "I can't afford it," consider that these cards can be opened with as little as $200 in many cases.
Once you get your card, you use it and pay the bill just like with any other credit card, and the issuer reports the account to the three major credit bureaus. Nowhere on your credit report will the account be labeled as a "secured card." It has the same impact on your credit as a standard or "unsecured" credit card.
There are a lot of banks that issue these, so your own financial institution is a good place to start. Many of the big U.S. banks such as Bank of America and Wells Fargo have their own secured cards. One personal favorite of mine is the Capital One secured card, which looks like a standard Capital One Platinum card and gives you the opportunity to expand your credit limit over time with either additional deposits or a solid payment history.
Down the road, once your credit has recovered and you can qualify for a better credit card, you can close your secured account and have your initial deposit refunded to you.
Why is it better than the alternatives?
With bad credit, you can also usually get an unsecured card made specifically for people in your situation. Or, you can also get a prepaid debit card that's accepted virtually everywhere and you won't have to worry about paying a credit card bill each month. However, a secured card has distinct advantages over both.
Unsecured credit cards designed for bad credit tend to come with extremely high fees and interest rates. For example, the First Premier Card comes with a $75 introductory fee, $6.25 monthly fee (waived for the first year), $75 annual fee for the first year ($45 after) and has a sky-high 36% APR.
These are incredibly high fees, considering that the card only starts with a $300 credit limit. To put this in perspective, if you carry just a $200 balance on this card each month, you'll end up paying $222 in fees and interest during the first year.
Prepaid cards don't give you the benefit of reporting to the credit bureaus. In other words, they do nothing to help solve the problem of your bad credit; they simply give you a way to pay for things without using cash. Plus, they aren't accepted as readily as credit cards in many places. For example, it can be extremely difficult to rent a car or pay for a hotel room with a prepaid debit card.
Once you have it, how should you use it?
Basically, treat the card like you're spending your own cash (in a way, you are). Obviously, you want to make your payments on time every month (35% of your FICO score comes from your payment history), but you also should make an effort to keep your balance low.
Of your FICO credit score, 30% comes from "amounts owed," which mainly refers to how much money you owe relative to your credit limits. Most experts agree that you should use less than 30% of that amount. For example, if you get a secured card with a limit of $500, try to keep the balance under $150. The lower the better, but make sure you use your card somewhat regularly in order to establish a good payment history.
Over time, your secured credit card will help your credit score in nearly every way possible. "Types of credit used" comprises 15% of your score, and if you don't have a credit card, you're not doing too well in this category. Another 10% comes from "new credit," and as your secured card becomes established, the age of your credit will increase and this category will improve.
A secured card can be an excellent step on the way to reestablishing your credit, while allowing you all of the freedoms that come with having a credit card.
Matthew Frankel owns shares of Bank of America. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Capital One Financial., and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.