Credit products can come in one of two forms: secured and unsecured. Secured credit products, such as an auto loan, mortgage, or home equity line of credit, are tied to collateral that can be seized if the accounts go delinquent. That’s why getting behind on a mortgage or auto loan, for example, can lead to the borrower losing their home or vehicle.
Unsecured credit products, such as most credit cards and student loans, don’t have any collateral tied to them. If they go delinquent, there’s no property for the lender to collect so the creditor will first look to collect from you. For this reason, getting approved for these products can sometimes be more challenging.
FREE TOOL: Are mistakes on your credit report hurting your credit score? Find out here.
Let’s Talk Security Deposits
Secured credit cards were created to open the door to credit for those unable to get approved for standard, unsecured credit cards. The collateral required for secured credit cards is usually a security deposit. Here are a few important things to know about the conditions often placed on this security deposit:
It’s typically equal to your card’s credit limit.
If, for instance, your security deposit is $500, you are generally able to make no more than $500 worth of charges to your card. However, if you make consistent, on time payments, a lender could potentially increase your credit limit without requiring a higher security deposit.
It cannot be used to make your monthly payment.
Any charges made to the card must be paid with other funds. If you fail to make your monthly payment, the amount owed will ultimately be collected from your security deposit by the lender. This could also hurt your credit.
It can be returned to you.
If your balance is paid in full and the account is closed, you will receive your deposit back. Or, if the lender extends an offer to convert the card to an unsecured credit card, you will likely also receive your deposit back at that time.
Think of the security deposit on a secured credit card like the security deposit on an apartment — these funds offer the landlord protection against damages, cannot be used to pay rent, and won’t be returned until after the renter moves out.
Pros and Cons of Secured Credit Cards
Just like any financial product, there are pros and cons to secured credit cards. Here are a few:
The credit requirements are generally less stringent than a regular credit card.
With many secured credit cards the risk falls on you – if you fail to pay, the creditor can pull the funds from your security deposit (unless your credit limit is higher than your security deposit). Therefore, the credit approval requirements tend to be more lenient.
They can help you build credit and establish good habits.
Secured credit cards are often reported to credit reporting bureaus just like unsecured credit cards, serving as a tool for building or rebuilding your credit. If you are able to establish the habit of making on-time payments, you can set yourself up for success with an unsecured credit card.
They can serve as a first step to a regular credit card.
By building or rebuilding your credit with a secured credit card, you can increase your chances of approval with an unsecured credit card.
They require a security deposit.
A security deposit is usually the required collateral for a secured credit card. The amount of the security deposit can vary depending on the card and may or may not be the same as your card’s credit limit.
They generally come with a lower credit limit.
While the credit limit varies depending on the card, many unsecured credit cards have a limit of just a few hundred dollars – or the amount you’re able to offer as a security deposit. If you have your sights set on making a larger purchase, a secured credit card might not be your best bet.
They can come with high fees.
From annual fees to interest rates, some secured cards are costly financial products to have. Make sure you shop around for the best secured credit card you can get approved for.
How to Transition Out of a Secured Credit Card
The good news about getting a secured credit card is that it usually doesn’t take long to qualify for more traditional credit cards if you exhibit consistent positive behavior. High on the list of factors that determine your credit scores is payment history — so one easy way to build or improve credit can be to make all your monthly payments on time.
Aside from that, you can work toward better credit by keeping your balances low (30 percent of your total credit limit or less). The length of your credit history is an important factor as well, and you can work on that one by simply getting a secured credit card and keeping it open. (It’s important to note, however, if you already have other open credit accounts, a new secured credit card could actually lower your average credit age.)
Payment history and credit utilization tend to be the two most influential factors in credit scoring, so focusing on these steps should go a long way in improving your credit. Before long, you might find yourself getting approved for a traditional credit card.
Learn more about a secured credit card that could be right for you.