What are secured credit cards?

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While standard unsecured credit cards have become a popular way to pay for goods and services, not all consumers and businesses are able to obtain these financial vehicles. For many consumers, this is often due to past credit issues, insufficient income, lack of adequate credit history or other event that make them a higher-than-acceptable credit risk for many creditors.

One solution that is now available to those who are unable to qualify for a traditional credit card is the secured credit card. In addition to helping consumers obtain a credit card they can use, secured credit cards may also help individuals improve their credit scores – and eventually qualify for a standard credit card.

Elements of a secured credit card

The “security” for secured credit cards is typically a deposit account maintained with the credit card issuer. This security deposit is used as collateral for the credit line being provided to the card user.

As mentioned above, many consumers are often unable to qualify for standard credit cards because creditors may consider them too high of a credit risk. By requiring this collateral, secured credit card providers lower their risk exposure to acceptable levels. They don’t have to worry as much about losing money because of a borrower defaulting on the secured credit card.

Besides the security requirement, a secured credit card works in the same fashion as an unsecured card. In fact, many secured credit card providers also offer standard (unsecured) credit cards.

Secured credit cards provided by banks in the Visa or MasterCard networks may be used for making purchases with merchants and vendors who accept Visa and MasterCard. These secured cards may also be used to obtain cash advances through ATMs, depending on the lender.

But just as with standard credit cards, it is essential that the holders of secured credit cards make their monthly payments on time, as this will have an effect on their credit report.

Types of creditors that provide secured credit cards

Financial institutions approved to issue traditional MasterCard and Visa credit cards may be approved to also offer secured MasterCard and secured Visa credit cards. MasterCard and Visa have their own guidelines and requirements for banks, credit unions and financial institutions who wish to issue their credit cards.

MasterCard and Visa are not lenders and do not provide credit cards directly to consumers. They instead approve financial institutions to issue credit and debit cards – with either the MasterCard or Visa brand logo – which are then used over their separate networks. MasterCard and Visa then processes the payments between member banks and merchants, as well as facilitate electronic fund transfers (EFTs). American Express, in contrast, issues its own credit cards.

The decision to offer secured credit cards inevitably rests with the financial institution approved to issue credit cards. Some banks and financial companies, for example, find secured credit cards to be an important marketing niche. Other banks and credit unions, however, often prefer to stick with traditional unsecured credit cards or debit cards.

In many ways, the debit card or prepaid card can function similar to the secured credit card, as the deposit balance typically sets the credit limit for the user.

How are credit limits set?

Although various creditors may follow differing guidelines, the credit limits on secured credit cards are usually a function of the security deposit or collateral for the secured card. The credit limit is typically set at or above the security deposit amount.

For example, if the borrower opens a secured credit card account with a $500 security deposit, then the card’s credit limit will probably be $500 (or sometimes higher).

Most secured card providers do allow borrowers to increase the credit limit by adding more funds into their security deposit account. So in the above example, if the borrower adds another $1,000 to the security deposit at a later date, then the credit line could rise to at least $1,500.

Why consumers use secured credit cards

Although secured credit cards function much like unsecured cards, they do come with a large cost: the security deposit, which is then used to establish the credit limit. Many consumers have varying reasons for paying the “extra cost” of secured credit cards:

  • Insufficient history. Some consumers are unable to obtain traditional credit cards because they don’t have any or enough credit history. More to the point, their credit reports show few active or recent credit entries – or none at all. With insufficient history, it may not be possible to generate a credit score, or at least one that qualifies. A secured credit card allows borrowers with no credit history to obtain a credit card – and then use their payments on that card to establish a positive credit history.
  • Low credit scores. Many consumers are unable to obtain traditional credit cards because of negative entries on their credit reports. Secured credit cards can help by providing many consumers with severely damaged or bad credit to obtain the credit card they need for many transactions. And as with credit builders, paying the monthly payments on time and keeping a low balance on the secured credit cards can help repair an individual’s credit record.
  • Safer transactions. Although consumers could just use cash to pay for their transactions, a credit card may offer a safer alternative. Instead of carrying thousands of dollars in cash or traveler’s checks, borrowers could use their money as security deposits for a secured card. They can then use the card to make purchases.

What happens to a secured credit card’s deposit?

Once a secured credit card holder has made their security deposit, the credit card issuer will deposit the funds into an account. Depending on the creditor and account type, the funds in this account may or may not accrue interest earnings.

It’s important to note that this security deposit is meant to be collateral for the credit account – and not a source for making scheduled or required payments.

If borrowers are late or delinquent on payments on their secured credit cards, the issuing bank, credit union or institution will not use the security deposit to make the payments. Rather the creditors will usually charge their standard late fees and penalties, as well as follow their established servicing guidelines.

The security deposit only comes into play if the borrower officially defaults on the secured credit card account. If that happens, the credit will cancel the account and then use the collateral to cover the default balance.

If unpaid fees and penalties have driven the total default balance past the credit limit, the security deposit may not be enough to cover the entire default balance. In such cases, the creditor may use other legal collection tactics to recover the unpaid remainder.

Secured vs. unsecured credit cards

Although secured and unsecured credit cards can be used at many of the same establishments, there are several differences between the two types of cards. First, most secured credit card issuers will accept the large majority of legitimate applicants who apply – and provide the required security deposit.

By contrast, in order to be accepted for an unsecured card, an individual must usually possess a minimum credit score and have acceptable credit history.

In addition, while both types of credit cards have interest rates that are charged on the balance maintained on the credit cards, the rates on secured credit cards may sometimes be lower than those of unsecured cards, because of the lower risk posed to the creditor.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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