Individuals who have never applied for any type of credit sometimes face a situation that will sound familiar to many; “I’m sorry, we can’t issue credit because you don’t have a credit history,” and many consumers then reply something to the effect of, “Yes, I know but how can I get credit if don’t have a credit history”?
Similarly, consumers with less than perfect credit are caught in the same Catch-22 as they’re often unable to get the new credit accounts they need to rebuild their credit.
But if lenders won’t issue credit or a loan unless you’ve established credit, how do people get credit in the first place? Or what if your credit has been damaged and you want to rebuild your credit profile?
Fortunately, there is one common way to establish or rebuild a credit history – by using a secured credit card. To begin, there are two basic types of credit cards: secured cards and unsecured cards. Most credit cards are unsecured, meaning credit is extended to you by a lender for anything from a hotel room to a hamburger – without any collateral.
Your obligation is to pay the lender back on the due date. However, the lender receives no security or collateral for extending you that credit, which means they’re carrying quite a bit of risk.
A secured credit card works in a similar manner, except that it requires collateral or security for the credit card. The security begins when you send your own funds to the secured credit card company, which is then used as a security deposit. The amount you send to the lender typically establishes your credit limit. If you send in $500 to open up a secured credit card, then your spending limit will be $500 or more, depending on the creditor and your creditworthiness. If you send in $5,000 your credit limit will be $5,000 or more.
Secured credit card companies set their own minimum amounts but there are cards with security deposits as low as $49.
Besides the security deposit, secured credit cards usually function in the same way as an unsecured card.
Each time you make a purchase with your secured credit card, that debt will be added to your account, and the lender will send you a monthly statement. The statement will show a minimum payment amount due, the interest rate, the due date and the outstanding balance on your card. You have a choice as to how much to pay each month as your statement arrives – as long as you make the minimum payment required by the lender.
Some secured credit card accounts offer an additional benefit: earned interest. In these situations, the secured card lender will place your security deposit into an interest-earning account. It’s not much, but any interest generated by your security deposit goes to you.
It’s important to understand that your security deposit will not be used to make payments on your behalf. You must make your payments based upon the terms of your agreement. If you fail to make your payments on time, the creditor will assess late fees. But the lender will not automatically use your security deposit to pay off your balance.
The security deposit will only be used once you are seriously delinquent and go into default on your credit card account. When that happens, the creditor will close your account and use the security deposit to settle the outstanding balance. If they end up with a surplus, those extra security deposit funds will be returned to you.
However, if the security deposit is not enough to cover the balance and all outstanding fees or charges, the credit card lender will usually try to go after the remaining amount via collections.
Secured credit cards should always be considered a short-term tool or tactic. After you have built up or rebuilt your credit, try to replace your secured credit card with an unsecured card – and get back your security deposit.
Different secured card lenders take various approaches to try to keep you as a long-term customer, especially if you manage your debts properly. Some will increase your credit limit, so that it is much higher than your security deposit. Others will convert your entire account into an unsecured credit line and return your security deposit.
There are many secured card options available for consumers. If you’re looking to build your credit profile and can’t get standard credit accounts, secured credit cards may be an option.
But remember that getting the card is only the first step. You need to make sure that you use it wisely and always pay on time. Otherwise, your late payments or delinquencies could end up inflicting more harm on your credit scores.