Secured Credit Cards: What You Need to Know

A secured credit card can help you rebuild or establish your credit score, and there are some good ones to choose from.Image source: Getty Images.

If you can't qualify for a traditional credit card due to a shaky credit history, one of the things you can do right away to start the process of credit improvement is to obtain a secured credit card. A secured credit card can do wonders for your long-term credit health, but unfortunately, these products aren't well understood by all that many people.

With that in mind, here's an overview of secured credit cards, how they work, and why you're better off using one than a prepaid debit card or another "bad credit" credit card product.

What is a secured credit card?

Secured credit cards work just like regular credit cards in most respects. They are on a major payment network (Visa, Mastercard, etc.), so they are accepted just like a regular credit card would be. You have a credit limit, receive a monthly billing statement, and make payments, just like you would with a regular credit card. And like a regular credit card, your payment history is reported to the three major credit bureaus.

The only big difference is that you'll have to put up a security deposit in order to get the card, hence the term "secured." While there are a few exceptions, the general rule is that your deposit will equal your initial credit limit. For example, if you deposit $1,000, you can get a secured credit card with a $1,000 credit limit.

How secured credit cards work

Your security deposit stays in a savings account (which may or may not pay you interest) for as long as you have the card, or in some cases, until you've built up a sufficient payment history and the issuer decides that you've graduated to an unsecured credit line. If you want your money back at any time, all you have to do is pay off any outstanding charges and close the account. Of course, since the point of getting a secured credit card is to build a payment history over time, it's advisable to leave the account open for a while.

Because the issuer has your deposit, they feel comfortable allowing you to make purchases and start building a credit history. After all, if you don't make the payments and default on your account, they can simply use your deposit account to pay the debt.

Additionally, thanks to your deposit and the limited risk to the credit card issuer, secured credit cards tend to have rather low expenses. Most secured credit cards have annual fees of less than $40 per year, and some even offer reward programs that allow cardholders to earn things like cash back and airline miles. Plus, most have APRs that are on par, or even better, than what many unsecured credit cards offer.

Many banks and credit unions have their own secured credit card products. While it's definitely worth comparing a few to find the best deal, your own financial institution is a good place to start your search. It can simplify your finances tremendously to have a credit card and checking account with the same financial institution.

Why not just use a prepaid debit card?

One logical question people often ask is "why should I go through the trouble of putting up a security deposit when prepaid cards are readily available?"

This is a fair question to ask. After all, a prepaid debit card will be sufficient for most of your purchasing needs. However, it can be difficult to rent a car or a hotel room without an actual credit card.

The real reason secured credit cards are smart ideas is that unlike prepaid debit cards, your account information will be reported to the credit bureaus and can help improve your credit score over time.

A secured credit card can help you build or rebuild credit

As I just mentioned, because you'll have a secured credit card and not a debit card, your account activity will be reported on a regular basis to the three major credit bureaus. Therefore, over time, a secured credit card can have a tremendous positive impact on your credit score -- especially if you develop a history of responsible use.

Your payment history is 35% of your FICO® Score, so by simply using your secured credit card and paying the bill on time each month, you'll help your credit score over time. In addition to this, here are a couple of other credit-building tips that you can use to maximize the benefits of your new secured credit card:

• Keep your balance low as a percentage of your available credit. Experts suggest using less than 30% of your available credit, and lower is even better. For example, the average FICO "high achiever" with an excellent credit score uses just 4% of their available credit.
• Even if your credit builds to the point where you can qualify for one of the best unsecured credit cards, keep your account open. The length of your credit history is a major factor in the FICO formula, and one of the things it considers is the ages of your individual credit accounts.

It's also important to note that when a secured credit card account is reported to the credit bureaus, it is indistinguishable from a standard, unsecured credit account. In other words, there's no "secured" designation on your credit report -- prospective lenders will just see that you have an open credit account in good standing.

Secured credit cards vs. unsecured credit cards for bad credit

It's also important to mention that there are unsecured credit card products out there designed for people who are trying to rebuild their credit. And these don't require any sort of security deposit. So, it might seem like a better idea than a secured card, at least on the surface.

Here's why they're not. These cards generally come with astronomical interest rates and fees, and also have extremely low credit limits (think $250-$300). While secured cards have interest rates that are competitive with most traditional credit card products, and often have little or no annual fee, the same cannot be said for these "bad credit" credit cards.

One common example of a card that targets consumers with shaky credit histories is the First Premier® Bank Credit Card. Take a look at some of these numbers. If you get approved for a card you'll pay a fee ranging from $25 to $95 before the account is even opened, an annual fee of $75-$100 the first year ($45-$49 after), and a $6.25-$10.40 "monthly service fee" after the first year. I have a credit card that literally gives me a free airline ticket every year that doesn't cost this much. On top of that, the card has a sky-high 36% APR.

The bottom line on secured credit cards

Bad credit happens. According to Experian, more than 37% of consumers have credit scores that fall in the "fair" or "poor" categories. In fact, when I graduated college years ago, I was one of them. And I used a secured credit card as part of my credit-rebuilding process (In full disclosure, I used the Capital One product mentioned earlier). I can tell you firsthand that it was a big help in gradually building a great credit score.

Do yourself a financial favor. If you can't qualify for a traditional credit card, put a security deposit up for a credit card with decent terms.