How Do Secured Credit Cards Work?

Using a credit card responsibly is the quickest way to build good credit, but there is a paradox here. Consumers often can't get approved for a credit card unless they already have a good credit score.

This is where secured credit cards come in. These financial instruments can help credit newbies and people with less-than-stellar scores escape this ambiguity by enabling them to establish their credit profiles.

What Is a Secured Credit Card?

Designed for consumers with limited or damaged credit, secured credit cards look and function a lot like unsecured ones. The only significant difference is that with a secured card, you’re required to place a refundable deposit upfront to guarantee your credit line.

The security deposit acts as collateral for the card issuer. Until you repay what you owe and close your account, it serves as a safeguard for banks to cover any missed payments.

Aside from reducing the risks for the secured credit card issuer, the cash deposit also improves approval odds for applicants.

While credit history is usually the key factor when it comes to determining your eligibility for a secured card, the line of credit you can get approved for depends directly on the security deposit you put down.

Note that most secured credit cards are fully secured, which means that the amount you put down becomes your credit limit - if you put down $300, you'll have $300 to spend.

Therefore, secured credit cards generally don’t provide the ability to borrow any money that you haven’t previously deposited. Keep in mind that the minimum and maximum amount you can deposit may vary widely by card, but you should be prepared to cough up at least $200.

Making timely monthly payments is just as important with a secured credit card as it is with other cards, and not just because the card issuer may keep your deposit if you miss a deadline. Build your credit by using the card responsibly, and, eventually, you’ll be able to get your deposit back and qualify for an unsecured option - one that doesn't require collateral.

After six months to a year of responsible use, secured credit cards may offer you a chance to upgrade your account directly to an unsecured option.

While not all secured cards come with such clear upgrade paths, you’ll be able to submit your application with another provider. Once you upgrade or simply close a non-delinquent secured card account, you’ll get your security deposit back.

Here’s a quick overview of how these cards work:

1. You place a refundable security deposit. This can be done using a bank transfer, debit card, or check, depending on the card. Some secured cards require you to place a deposit upon application, while others allow you to do so once you get approved.
2. The amount of cash you deposit becomes your credit limit. Spending less or just as much as you can afford to repay benefits both the cardholder and the credit card company in the long run. Remember that most secured cards let you increase your spending power by adding more money to your security deposit over time.
3. The credit card issuer keeps your deposit as collateral. The funds are usually held in a non-interest-bearing custodial account.
4. You use your secured card just like any other credit card. Note that purchases and payments are the same as with any unsecured credit card. Although you can spend up to your credit limit, we don’t recommend it. Keeping your credit utilization ratio as low as possible is advisable on credit-building cards. You’ll need to pay your bill by the due date each month, and any balance you carry will accrue interest from month to month.
5. You’ll get the security deposit back when you close your account. Note that you won’t be able to get a refund of your cash deposit unless you repay what you owe and bring your account balance to zero first. After completing this step, you’ll get a check or bank transfer from the credit card company returning your deposit.

Secured vs. Unsecured Credit Cards

Your credit score determines whether applying for a secured credit card makes sense for you. As they don’t require a security deposit, unsecured credit cards present a greater risk for credit card issuers. That’s why most card companies require their applicants to prove that they’ve already built solid credit habits that are preferably reflected through good to excellent credit scores.

If you’ve ever been credit-card hunting, you’ve probably come across unsecured credit cards that are touted as being easy to qualify for, even for bad-credit applicants. Bear in mind that these options usually come with extremely high fees.

Until your credit is good enough to meet the eligibility requirements of a low-fee unsecured card, we highly recommend applying for a secured solution.

In addition to the security deposit requirement and fees, another important difference relates to interest rates. Unsecured credit cards usually feature an APR range such as 14.99% to 24.99%. The deal is simple in most cases - the higher your credit score, the lower the interest rate.

Meanwhile, secured credit cards work a little differently and offer just one variable APR - 24.99%, for example. Given that this rate is typically relatively high, you must pay your credit card bills in full every month to avoid interest charges.

Secured vs. Prepaid Debit Credit Cards

Offered by some of the most popular credit card networks such as Visa, Mastercard, and American Express, at first glance, prepaid debit cards may seem very similar to secured credit cards. While both card types require you to deposit money before you can start using them, there are significant differences between the two.

With a prepaid debit account, you are using your own money to make purchases, not the funds borrowed from the card issuer. There isn’t a security deposit involved - you add money to your prepaid card account, and the card issuer uses these funds to pay for your purchases.

By now, you are probably aware that prepaid debit cards don’t extend any credit, which means that your activity through these accounts isn’t reported to consumer credit bureaus.

To put it simply, unlike secured cards, the prepaid option cannot be used for credit-building. Also, note that these accounts often come with fees secured credit cards don’t impose.

Using a Secured Card Effectively and Responsibly

Whether you damaged your credit due to poor financial decisions or you’re just starting to build your credit profile, relying on prepaid cards or cash to make all your purchases won’t do anything to improve your credit as such activity doesn’t get reported to the major credit bureaus.

Although it requires a security deposit, if handled properly, a secured card could be the best ally on your credit-building journey.

Here are a few tips on how to use your card effectively to improve your credit and prove to card issuers and credit reporting agencies that you know how to manage your finances:

• Don’t apply for the first secured credit card that you stumble upon. Make sure to shop around for the best rates, fees, security deposit options, and upgrade possibilities.
• Ensure that the card issuer you’ve chosen to apply with reports to the three major credit bureaus (Equifax, Experian, and TransUnion).
• Try your best to use the card sparingly and make one or two small purchases every month. That way, you’ll keep your credit utilization ratio low.
• Make sure to pay your credit card bill in full every month before the due date comes to avoid interest charges and stay true to your mission of building credit.
• Set up automatic monthly payments to avoid late fees.
• Keep an eye on the changes in your credit report over time; once you see a meaningful improvement in your score, ask your card issuer about the possibility of upgrading to an unsecured card.

How a Secured Card Helps Build Credit

As long as the credit card company reports your activity to the three major consumer credit agencies, there are quite a few ways a secured credit card can help you build or rebuild your score.

As you use your secured credit card to make purchases and pay your balance, credit bureaus receive the information about how much credit you use and whether you repay what you owe. That’s why paying your bills on time reflects positively on your credit report and shows lenders you’re responsible.

This is important as keeping a clean payment history puts you on the right path to qualifying for an unsecured card.

Moreover, keeping a credit line open can also help boost your score as it changes your credit utilization. However, keep in mind that applying for secured credit cards to increase the total credit available won’t make sense unless you try and keep your credit utilization ratio below 30%.

Once again, paying your balance in full each billing cycle can help you do that.

How Quickly Does a Secured Card Build Credit?

With most consumers, it takes about a year of careful use of a secured credit card to boost their credit scores and become eligible for an unsecured one. Note that most issuers will let you transfer your secured credit line to an unsecured option without having to open a new account.

But even if you have to apply for a new account after using the best-secured credit card to rebuild your credit, you’ll enjoy a wide variety of benefits offered to users with good or at least fair credit scores, such as lower APR, rewards, and more competitive fees.

Remember, when this time comes, all the months you’ve spent building your credit will have been worth it.