Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
Secured credit cards are a good way to establish credit if you have no credit history or a history of prior credit problems (e.g., late payments, charged-off accounts, and bankruptcy). Secured credit cards are backed by money that cardholders deposit with the credit card issuer. In other words, the amount deposited serves as collateral (security) for the credit card limit in the event that a borrower misses payments. In this case, money deposited with the lender is used to cover the credit card balance. Some creditors will draw money from a cardholder’s account after only one late payment while others may do so only after a severe delinquency (e.g., when payments are 3 or more months past due).
The amount of money required to deposit for a secured credit card varies with the card issuer and can range from several hundred dollars to $1,000 or more. Secured credit card limits are usually 50% to 100% of the amount deposited. Thus, if someone makes a security deposit of $1,000, the credit card limit will generally be $500 to $1,000. In rare instances, cardholders may be allowed to borrow 150% (one-and-one-half times) or 200% (double) the amount of the deposit. Usually, the creditor will pay interest on all or part of cardholders’ security deposits. Depending on the credit card issuer, funds may be placed in a savings account, money market account, or certificate of deposit (CD). Some lenders require secured cardholders to have a savings or checking account with their bank before a secured credit account is opened.
Some card issuers will increase a cardholder’s credit line without additional deposits if timely payments are made for a specific period of time. Others will only allow cardholders to increase their credit line after depositing additional money. Secured credit cards often have higher interest and fees than unsecured credit cards that do not require a security deposit. For this reason, secured credit cards should be thought of as a “stepping stone” to unsecured credit cards. When an unsecured credit card is obtained, a secured card can be canceled and the money on deposit will be returned. It may take several months, however, to allow the card issuer to post remaining charges, if any. Some secured card issuers will automatically convert secured cardholders to an unsecured card after a certain number (e.g., 18-24 months) of on-time payments. Others will only do this upon customer request.
Below are some major advantages and disadvantages of secured credit cards:
Advantages of Secured Credit Cards
¨ Secured cards are way to establish credit when someone has had a poor credit history or has no credit history (e.g., young adults and recent immigrants) and is, therefore, “invisible” to potential creditors.
¨ Secured credit cards are available through large, well-known banks including Bank of America, Bank One, Capital One, Chase, Citibank, and HSBC. They can also be searched for easily at Web sites such as www.bankrate.com, www.cardtrak.com, www.cardhub.com, and www.findsecuredcards.com.
¨ Most secured credit card issuers report cardholders’ payment history to at least one major credit bureau. Borrowers should check to make sure that timely payments are being reported because a major reason for having a secured credit card in the first place is to establish or re-establish a positive credit history. Reports to credit bureaus can help raise a borrower’s credit score if at least the minimum required payment is made on time for about a period of about six consecutive months to a year.
¨ Secured credit cards look exactly like unsecured credit cards (e.g., Visa and MasterCard). There is nothing on secured credit cards to indicate that they are “different,” nor will merchants know that a credit card is secured when they are obtaining authorization for a purchase.
¨ Secured credit cards can be used widely at ATM machines and for the purchase of products and services.
Disadvantages of Secured Credit Cards
¨ In addition to higher interest and fees than most unsecured credit cards, some secured credit cards charge one-time upfront application or processing fees when a new account is opened.
¨ All applicants for secured credit cards are not approved for credit cards, even if they have the required deposit. Credit card issuers also have other guidelines and criteria that borrowers must meet.
¨ Secured credit cards can be used as “bait” for deceptive “Bad credit? No problem” scams where high up-front fees and/or expensive “900 number” telephone charges are required in an unsuccessful attempt to obtain credit. Some tip-offs of a scam are words like “guaranteed approval,” “get a card right now,” and “apply immediately.”
¨ Cardholders must accept the interest rate paid by card issuers on their savings deposit, which may be less than rates paid by local banks and credit unions. In addition, interest may not be paid on a portion (e.g., the initial $500) of a cardholder’s deposit.
¨ Cardholders cannot easily withdraw the money in their savings account that is being used to secure the credit card. Withdrawing the security deposit will generally require closing the credit card account and paying off the outstanding balance and applicable fees.
¨ If a credit card account is reported to credit bureaus as a secured credit card, the cardholder’s credit score may be lowered, even if bills are paid on time.
Bottom line: secured credit cards can be a valuable resource to those who otherwise might not be approved to receive credit. However, they frequently come with high expenses and are occasionally associated with outright scams. Consumers are advised to carefully read the “fine print” in printed cardholder agreements and ask questions about a secured credit card’s terms and conditions via its toll-free “800” number. Never agree to the terms of a secured credit card over the phone without reading them first and stick with secured credit cards issued by well established financial institutions.
Think of a secured credit card as the means to an end: i.e., building a positive credit history to eventually qualify for a lower-cost unsecured credit card. Once a secured credit card is received, make small monthly purchases and pay the bill in full. After making timely payments for about a year, apply for (or convert to) an unsecured credit card. At this point, the fees and expenses associated with a secured credit card will no longer apply and the money initially deposited as collateral can be returned. In the meantime, a secured credit card works exactly like other credit cards except for the required deposit. Cardholders can elect to pay any amount between the minimum payment and full balance and bill-paying activity is reported to credit bureaus.
Secured credit cards are predicted to become increasingly popular with college students and other young adults. After February 22, 2010, credit cards cannot be issued to consumers ages 18-21 who do not have adequate income (to repay debt) or a co-signer. The security deposit required by a secured credit card is one way to prove that young credit cardholders have the capacity to repay their debts. As noted above, the amount of money placed on deposit will be used to determine their credit limit.
Finally, it is important to note that secured credit cards are just one type of secured credit. A car loan is another type of secured credit where collateral is pledged. If timely loan payments are not made, the car for which the loan is made can be repossessed. Secured credit is also used in association with the purchase of a home. Both mortgages and home equity lines of credit are secured with real estate. If timely payments are not made, foreclosure can occur and the home will be seized by the lender to repay the outstanding debt.