How Do Secured Credit Cards Work?
Have you ever heard of decision fatigue? It’s the idea that humans can only make so many choices in a day before we simply wear out our ability to continue making good decisions.
Once decision fatigue sets in, we start opting for what’s easiest. We choose whatever requires the least amount of effort and willpower to see through.
When it comes to your credit cards, this can mean a debt disaster waiting to happen. It takes a lot of effort, willpower, and responsibility to avoid racking up a big balance that you can’t afford to repay.
Sometimes, it’s just plain hard to resist the temptation of charging to your card. Swiping your plastic means instantly getting things you want to treat yourself to. It's easy to find yourself charging something to your card that you wouldn’t normally buy. But you might have already crossed that decision fatigue threshold for the day, so you end up making a spending choice you’ll regret later.
It’s even harder to resist spending temptation when your credit card features a sky-high limit. When I was 21, I applied for a credit card because I needed a new one - and the issuer sent me a card with a $20,000 limit. That was more than I had in cash in my checking and savings accounts combined! No wonder so many people find themselves in trouble and in debt with credit cards.
Even with all this temptation, credit cards can help your financial situation when they're used properly. Credit cards can help you build a positive credit history - if you pay off the balance off each month and always make your payments on time. This behavior can help you build and maintain a good credit score.
Can you balance the desire to use credit as a tool, and the temptation to overspend and end up in debt? Well, if you’re just getting started, secured credit cards can help.
What Is a Secured Credit Card?
A secured credit card is a credit card that requires a security deposit for approval. Typically, the amount you put down for your security deposit ends up being the amount of credit you have available to you. This a great option for someone with no credit or poor credit because the security deposit enables approval without a good credit score.
“You put down a security deposit as collateral,” explains Noa Rodriguez-Hoffman, a CFP® and the founder of Socialyte Capital. “The amount of money that is put down as collateral will be the amount of the credit card limit.”Rodriguez-Hoffman says you need to make your security deposit when approved for the card. The deposit is eventually refunded to you when you pay your account in full and close it.
Marcio Silveira, CFP, CFA, CAIA is a financial planner who runs Pavlov Financial Planning. He points out that your secured card can be tied to an asset, as well.
“That’s typically a bank CD or securities in a taxable investment account,” he says.Silveira’s personal story illustrates one way that secured credit cards can help someone start building credit if they don’t have any previous credit history.
“When I moved to the United States 12 years ago, I had no credit whatsoever,” he shares - even though he had a bank job. He took advantage of that role and the resources available to him and opened a secured credit card with his bank.Silveira says this was extremely helpful for him. It allowed him to start building credit as soon as he became a permanent resident.
“It was secured by a certificate of deposit. I had to leave my deposit in the bank CD for 3 years,” Silveira says. His initial deposit and subsequent line of credit was $5,000.
“After the initial 3 years, I redeemed my CD and the card became a regular, unsecured credit card so I could maintain the account,” he explains.
The Pros and Cons of Secured Credit Cards
These cards come with a lot of benefits. Specifically, secured cards provide a legitimate way for you to build or improve credit. However, this credit-building doesn’t happen automatically. First, you must consistently take the following actions:
- Make payments on time and in full
- Keep your credit utilization below 30%
- Don’t apply for a lot of new credit cards or close old ones
Besides the pro of credit-building, secured credit cards are also great because they tend to offer better terms than the kinds of unsecured credit cards you can qualify for when you have no credit or bad credit. In other words, the kinds of credit cards made for poor credit may come with astronomical interest rates - which will cost you if you carry a balance over from month to month.
Another pro: that security deposit you put down is refundable. Once you’re ready to move on from your secured card and you’ve paid off all balances, you get your deposit back.
There are some cons as well, though. For example, the security deposit requirement can be difficult to do if you're struggling to save money in the first place.
Plus, secured cards don't usually come with rewards. On the flip side, unsecured cards can come with rewards. Unsecured cards that are rewards-based can help you earn points, miles, and cash back. Therefore, if your credit score is high enough to get approved for an unsecured credit card, that might be a better option so you can earn rewards. However, if you fear you might fall into debt, forget about the rewards and stick to the secured cards.
There are some exceptions. In other words, some secured cards do offer rewards. Most notable is the Discover it® Secured Credit Card. This card has no annual fee and comes with lots of great perks. For example, you can earn cash back and get access to your FICO credit score to track your progress.
Then, after a year of using the card, you can switch to an unsecured card with Discover®. You’ll get your deposit back and you might get a higher credit limit, which helps keep your credit utilization low if you don't rack up a large balance.
How to Decide if a Secured Card is Right for You
Rodriguez-Hoffman says secured cards are best for people with bad credit, or a score of 630 and below. She also points out these are a good option for people with no credit history.
“It usually takes about 12 to 18 months of responsible use to be able to qualify for an unsecured card,” she explains.When it comes to actually using the card, the best cardholders are those who can afford the security deposit. Make sure you save up for that before you apply for the card. Good cardholders will also be people who can keep their credit utilization low.
“Secured cards are best to use on small purchases, like groceries,” Rodriguez-Hoffman says. You want to make sure you can pay off the card in full each month.So how can you decide if a secured card is right for you? If you want to improve or build credit, can put down a security deposit, and will maintain a low credit utilization ratio, then this could work for you.
How to Responsibly Use a Secured Credit Card
If you choose to use a secured card, read the fine print and understand what’s in your credit card agreement. These are still credit cards, and you can wind up in debt if you don’t pay your balance.
It’s a little bit like bowling with the gutter guards up. You’re still bowling - the guards are no guarantee of hitting the pins. But they do help you avoid the major pitfall of landing a ball straight in the gutter.
With secured cards, you’re still charging purchases to a line of credit. The “gutter guard” of needing to make a deposit first helps avoid falling into the trap of massive debt, but it doesn’t guarantee you’ll stay out of financial trouble.
Silveria and Rodriguez-Hoffman advise watching out for the following trouble spots:
- Getting a card with high fixed fees (including annual fees)
- Failing to repay your balance and triggering high interest charges
- Thinking your secured card is a prepaid card - remember that you will get a monthly bill for the charges you make and you will eventually need to pay the balance off
Secured or unsecured, anytime you get a credit card it's important to manage your spending. But if you can use your secured card to make small purchases that you need to make anyway, it can be a great way to build and maintain good credit.