How to establish credit is a common concern for younger individuals. While they may be ready to make their first significant purchases, the lack of any credit often presents a major hurdle. Similar obstacles confront those with the task of rebuilding poor credit history. Thankfully for both groups, a secured credit card allows each to start (or restart) their credit journey with the goal of financial independence. How do secured credit cards work? Let’s take a closer look.
What is a secured credit card?
A secured credit card is one backed or “secured” via a cash deposit paid by the cardholder. Similar to how a rental deposit protects a homeowner against damage or default by the renter, the cash deposit protects the issuer of the credit card should the cardholder be unable to make payments.
The process of acquiring a secured credit card is straightforward. The card issuer assesses the applicant’s financial standing and determines an appropriate deposit amount to secure the card.
Even those with bad credit can qualify, and deposits most often start at $200 with a ceiling of $5,000 (some issuers do offer higher thresholds). The cash deposit effectively becomes the cardholder’s credit limit — how much they can charge with the card.
Secured credit cards carry with them some distinct differences when compared with more common credit cards. For example:
- Secured versus unsecured: In addition to an unsecured card not requiring a deposit, approval and credit limit is based on an applicant’s FICO score and their overall credit history (their creditworthiness). Unsecured cards also come with fewer fees, lower interest rates and robust reward programs.
- Secured versus prepaid debit: A prepaid debit card is covered by a cash payment — you put up $250, you can spend $250 using the card. Once the $250 runs out, you have to “reload” the card with more funds to use it again. While a secured credit card impacts your credit, a prepaid debit card does not.
Pros and cons of secured credit cards
As with any payment method, there are pros and cons to using a secured credit card.
- Function as a credit builder: A secured credit card’s primary purpose is to help those with no credit start building their history.
- Function as a credit re-builder: Similar to how it helps someone start their credit journey, secured cards also help previous credit histories get back on track.
- Reporting to credit bureaus: Your activity from the secured credit card is reported to credit bureaus, just as it would with an unsecured card. Good habits are rewarded with good credit scores (remember, the opposite is true too).
- Several useful benefits: Many secured cards feature benefits similar to an unsecured card, including cell phone protection, credit monitoring, identity theft alerts and travel insurance.
- The opportunity to graduate to an unsecured card: Use a secured card regularly and responsibly, and some card issuers provide a path for graduating to an unsecured card. Some issuers offer this in as few as eight months.
- The security deposit: The main feature of a secured card is also its biggest drawback. For many individuals that require the use of a secured card, producing a deposit to attain the card is not always easy.
- The low credit limit: Even though a secured card’s central premise is to slowly establish credit, the low credit limits — in some instances as low as $200 — can be highly restrictive.
- Fees and interest rates can be excessive: For an individual attempting to create or rebuild credit, any extra fees can prove a burden. Due to the risk involved for the issuer, interest rates are well above those of a typical card. Many secured cards also feature annual fees, some as high as $100 or more. Others have administrative or operational fees. The issuer, however, cannot levy fees of more than 25% of the card’s credit limit within the first year.
- Rewards are non-existent: With one rare exception — the Discover it® Secured — rewards programs on secured cards are scarce. Even the Discover card program is limited in scope.
- Not all issuers allow you to graduate: Closing a secured card early or without the support of the issuer to graduate to an unsecured card may harm your credit history.
How to transition to an unsecured card
From the point of approval, an individual can work towards qualifying for an unsecured credit card. Issuers may vary slightly on its terms and requirements. We will use the popular Discover it® Secured card as an example to help you grasp the basic tenets of upgrading to an unsecured card.
With the Discover card, after eight months of responsible card use — regular, modest charges and paying off your monthly balances in full — the company starts automatic reviews of your account. The reviews determine your eligibility for a refund of your security deposit and conversion to an unsecured card.
If approved, the issuer will offer to transition you to a new, unsecured card. You may also choose to apply for an unsecured card through a different issuer. The approval process, however, might prove easier with the issuer where you’ve already established your credit.
In either case, closing one credit account and opening another, even through the process of graduation, will hurt your credit by reducing the age of your credit accounts. Luckily, the hit is only temporary.
The bottom line
Whether you aim to build or rebuild your credit foundation, a secured credit card proves the simplest and most straightforward method to achieve your goals. Yes, a deposit may be hard to come by. The card fees and lack of rewards may also be taxing. However, as a tool towards ensuring your financial health, the short term struggles are well worth the long term gain.
Please Note: Information about the Discover it® Secured has been collected independently by TheSimpleDollar.com. The issuer did not provide the details, nor is it responsible for their accuracy.
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