Having a credit card tucked in your wallet offers a lot of financial flexibility. Not only can it help in a financial emergency when you’re short on cash, but it can also be necessary for simple tasks like making travel reservations.
Most importantly, it can also help build or rebuild your credit. But if you have a bad credit score (or a limited credit history), you might experience difficulty actually qualifying for a credit card. So here’s the question: how do you build credit if you can’t get approved for a credit card? The answer: get a secured credit card.
How does a secured credit card work?
Secured credit cards work much like unsecured credit cards. The main difference is that the issuing bank receives extra security in the form of cash collateral. Here’s how it works:
You deposit a predetermined amount of money into the bank, which is held in an account that is off-limits to you. The amount required typically ranges between $200 and $500.
How to Use a Secured Credit Card
You can then charge up to that amount on your secured credit card, using it anywhere a regular card is taken. This includes both online and in-person retailers.
Once your billing cycle ends and you’re ready for your bill, you should pay off the full charge in order to prevent interest from accruing. Unfortunately, you can’t use the funds from your escrow account, so it’s really like having an unsecured card.
You must make at least your minimum payment, although paying off your balance in full is ideal. You’ll likely have a high APR, so it’s best to avoid carrying any balance on your secured card. If you get a secured credit card through a credit union, you might qualify for lower interest rates if you anticipate using your card frequently.
Defaulting on a Secured Credit Card
If you default on the credit card balance, the bank keeps the money you initially deposited, so the risk is significantly reduced for them. When you’ve responsibly managed your secured card for a certain period of time, you can upgrade to an unsecured card from your credit card issuer.
When that happens, you’ll receive your deposit back. You might not yet qualify for a credit card with a robust rewards program or other perks, but you won’t need that cash collateral to get approved. Secured credit cards are a stepping stone to re-entering the world of credit.
How to Build Credit with a Secured Credit Card
Not only does a secured credit card give you access to credit when you wouldn’t otherwise qualify, it also helps you to boost your credit score — when used responsibly. Credit card issuers know that secured cardholders need help building their credit, so they generally report to one or more of the three major credit bureaus.
Some may even report to all three: Experian, Equifax, and TransUnion. It’s best to confirm with your bank or credit union before signing up for a secured card. But unlike payday loans, you’ll start to build a monthly history of positive payments, assuming you pay your bill on time.
How does a secured credit card improve your credit history?
The largest percentage of your credit score depends upon how consistently you pay your debts each month. Any late payment that is 30 days or more overdue can be reported to the credit bureaus.
You then get a separate negative entry every subsequent 30 days that it’s late. So if it takes you three months to become current on your credit card bill, you get three separate negative items, with each one hurting your credit score. And while many creditors report your late payments, they don’t always bother reporting your on-time ones.
Whatever type of payment history you have on your credit report — whether good or bad — represents 35% of your credit score. That’s the highest allocation out of everything that goes into your credit score.
So using your secured card and making your payments on time will help you build a good credit history. Unfortunately, if you miss a single credit card payment, you will miss out on the opportunity that secured credit cards offer.
Advantages of Using a Secured Credit Card
- Being able to use a credit card – Obviously, one of the advantages of a secured card is having a line of credit available to you.
- Having the opportunity to build or rebuild your credit – This is the main reason people get a secured credit card.
- No limits on where you can use it – Most banks partner with well-known credit card brands like Visa or MasterCard. This allows you to use your secured credit card anywhere these brands are accepted.
- Lower interest rate – While the interest rate may be high, if you have bad credit, chances are that it will be lower than if you managed to qualify for an unsecured credit card. Plus, secured cards start with a relatively low credit limit, so you don’t have the temptation to charge huge sums of money.
- Earn interest on your deposit – Another little-known benefit to having a secured card is that you can oftentimes earn interest on your deposit, depending on the bank you choose.
It’s wise to shop around for the best secured credit card. Some financial institutions really do try to offer terms that are attractive to both of you. While you can see what’s available with national banks, many community banks and credit unions are better champions for credit building products.
Disadvantages of Using a Secured Credit Card
- Security deposit – A major negative is that you need cash upfront to qualify for a secured credit card. Not only do you have to have at least a few hundred dollars saved up in advance, but you’re also not able to use it while your card is active.
- Your money is tied up – Even if you’re earning a bit of interest on the account, the money is completely tied up. That means you should really focus on creating another level of savings to have on hand so that you’re not counting on your secured card for short-term cash flow issues.
- Annual fee – Another potential disadvantage with a secured card is that some banks require an annual fee, sometimes as much as $50 each year. This can add to the financial burden already required with your deposit. It’s important to find a card that helps you achieve your financial goals, rather than hinder them.
What’s the difference between a secured credit card and an unsecured credit card?
Unsecured cards don’t require a deposit which means they’re more of a risk to credit card companies. They typically require at least average credit. Good or excellent credit is required for the best ones.
What’s the best way to use a secured credit card?
Map out a plan to use it effectively, particularly for the purpose of building credit. First, think about what you’re going to use your secured card for.
If you want to use it to build your credit history, consider charging a small amount on the card each month, and then pay off the full month to avoid accruing interest. The amount doesn’t matter, so you could use it just for your cheapest monthly bill, then repay it as soon as the billing cycle ends.
Upgrading to an Unsecured Card
After you’ve got this pattern down for several months, reach out to your bank to determine when you’re eligible to upgrade to an unsecured card. You might be able to qualify in as little as six months to a year.
Also, find out how quickly you’ll get your security deposit and earned interest back. You can even find out the timeline for upgrading to a better card at the beginning of your card usage because that can serve as motivation for making those on-time payments each month.
Consider Leaving the Account Open
When you get an unsecured credit card, see if the credit card issuer will upgrade your current account rather than opening a new one. That’s because another factor influencing your credit score is your average account age.
Rather than adding a new credit line that brings down your average, you can instead enjoy a longer account period. Finally, keep up a relationship with your bank, especially if it’s local. You might start with a secured credit card, but you can make it easier to qualify for other financial products in the future if the bank is familiar with you.