If you’ve ever received an offer in the mail for a secured credit card, you might wonder what that means. How is a secured credit card different from a “regular” credit card, and why would I want one?
Here’s the situation: Most credit cards on the market today are unsecured credit cards, what you would probably think of as “regular” credit cards. With an unsecured credit card, you charge your purchases to the card and in a month or so you get the bill for whatever you bought. You pay off the card, or, if you can’t afford to pay it off completely, you get charged interest on the balance that you left unpaid. If you continue to make your payments on time each month, the bank that issued the card continues to let you buy on credit, trusting that you will pay each month. The bank does not require you to put up any collateral against the temporary loan it is giving you; it is simply trusting you to keep paying. However, if you fail to pay you will hurt your credit rating and the bank may sue you.
Not everyone can get one of these regular, unsecured credit cards. Usually, this is for one of two reasons:
- You have had a regular credit card in the past and you failed to pay your bills or paid them late many times, forcing the bank to take the card away from you and hurting your credit rating, or
- You have never had a credit card and do not have a credit history for the bank to judge the likelihood that you will pay off your debts.
Regardless of whether you have a bad credit history or no credit history at all, the result is the same: the bank that issues the credit card does not have a good reason to trust you. So, they refuse to give you a regular, unsecured credit card. (Or they could you offer you an unsecured credit card for people with bad credit that has a limited credit line and higher fees.)
Which brings us to secured credit cards.
A secured credit card works just like an unsecured credit card except for one big difference: you must put down a security deposit in order to get the card. In this way, it is just like putting down collateral to secure any other type of loan — you are agreeing to let the bank have your security deposit if you fail to pay your credit card on time.
We often compare a secured credit card to the renting of an apartment. In order to rent an apartment, you must put down a security deposit, which your landlord holds until you move out. Assuming you don’t damage the apartment and you always pay your rent, your landlord gives you back the deposit when you move out. If you fail to pay your rent or you cause damage, the landlord may keep all or part of that security deposit to cover the costs you haven’t already paid.
A secured credit card works in a similar way. You put down a deposit, and you get a “credit line” equaling the amount of that deposit. Each month you make purchases with the card and you pay all or part of the balance on the card. When you no longer want the card, you cancel your account and the bank returns your security deposit, assuming you’ve paid your card balance down to zero. If you haven’t paid off the card completely, the bank takes all or part of your security deposit to cover what you owe.
An example: you deposit $500 to get a secured credit card. You can now use the card to make purchases up to $500. Each month you pay off the card’s balance. At the end of a year you decide you don’t want the card. You cancel it and the bank returns your $500.
If you’re wondering why you would put down a security deposit to use a credit card when you could just as easily use that deposit to make the purchases in cash, the reason is this: using the secured credit card can help you build a good credit history. The bank that issues your secured credit card should report to the credit agencies that help determine your credit rating. If you always make your payments on time, your credit rating improves. In the future, banks will now have a reason to trust your ability to handle credit. This could lead to you being accepted for a regular, unsecured credit card that does not require a security deposit.
So, in summary, a secured credit card is a credit card that requires a security deposit and can help you build a good credit history if you are new to credit or have had credit problems in the past. An unsecured credit card requires no deposit and is for those people who have already proven they can use credit responsibly.
One final note: some secured credit cards have very high fees and very high interest rates. If you are thinking of getting one, we would suggest only getting a card from a major bank that keeps its fees to a minimum. See our Secured Credit Cards page for a good list to consider.