Most major credit card issuers offer two types of credit cards: secured and unsecured. The main difference is that with a secured card, you pay a cash security deposit to the issuer to ensure your line of credit.
If you have hopes of one day applying for a car or home loan, having a positive credit history can increase your chances of approval. Secured credit cards are one tool that can help you build or rebuild your credit history. Here’s what they are and how they work.
A secured credit card is a type of credit card that requires the borrower to pay a deposit upfront to the issuer—which is held as collateral in case the borrower fails to make the monthly payments. In most cases, the security deposit is equal to the amount available for the borrower to spend, also known as the credit limit.
If lenders report your monthly payment history to the three major credit bureaus (Experian, Equifax, and Transunion), secured cards can be a useful tool for building and improving credit—especially for people with little to no credit history or those with a poor history, says Freddie Huynh, vice president of data analytics with Freedom Debt Relief, the nation’s largest debt negotiator with a focus on debt relief education.
If you have no credit history, your credit score is nonexistent. This may look risky to lenders and will inhibit your ability to qualify for a traditional credit card. On the other hand, having a bad credit score (300 to 579) can also impact your ability to qualify. In these cases, secured credit cards are a good option to consider because they’re easier to qualify for than an unsecured card.
When deciding between a secured or unsecured card, checking your credit score may help you determine which route to take. It’s also important to know the major differences between the two types of cards:
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Qualification requirements: In general, unsecured cards have much higher requirements for approval. So if you have little to no credit history, then secured cards will be a better option for you. This is because secured cards are designed for those who are still building their credit, so they have lower or no credit score requirements to qualify; and they require the applicant to put down a cash deposit as collateral in case they fail to make payments.
Credit limits: Since the deposit amount also determines the credit limit, secured cards often have lower credit limits than unsecured cards.
Application process and interest rates: Unsecured cards are a type of credit card that do not require a deposit at account opening, so there is higher credit risk involved for the lender. So the issuer uses information from the credit card application to determine if the borrower qualifies, such as their credit score, payment history, and income, which makes these cards more difficult to qualify for. Since this screening process is more rigorous, unsecured cards often have lower interest rates than secured cards.
What you can use them for: That said, secured cards actually work very similarly to unsecured cards after approval. Both can be used to make everyday purchases such as gasoline or groceries, up to a specified credit limit, says Huynh. And some credit card issuers also offer benefits for both secured and unsecured credit cards such as cash back or points that can be redeemed for travel or gift cards.
Repayment and reports to the credit bureaus: At the end of the billing cycle, both types of cards give you the choice to pay in full to avoid paying additional interest charges—or you can pay down the balance over a longer time period (as long as you meet the minimum monthly payment). If you regularly make payments on time, this can have a positive influence on your credit scores.
Paying late: If you forget or can’t make the minimum monthly payments, both secured and unsecured card issuers may charge off the account after 120 to 180 days and send it to collections, which negatively impacts your credit score. For secured cards, issuers will use your security deposit as payment to cover the charges, and you may still owe additional fees and interest payments.
Secured credit cards are a great way to build your credit if you use them responsibly. But first, here’s a breakdown of what makes up your FICO credit score:
Payment history (35%): how you’ve paid your accounts over the course of your credit
Credit utilization (30%): how much available credit you are using currently, divided by your total available credit
Length of credit history (15%): how long your accounts have been open
Credit mix (10%): what kinds of credit accounts you have (e.g., auto loan, student loan, mortgage)
New credit (10%): how long ago you opened your most recent credit account
If you’re looking to build your credit with this type of credit card, you should focus on forming good financial habits such as:
Making payments on time. Payment history accounts for 35% of your FICO credit score and is one of the strongest predictors of your ability to repay your debts. This is extremely important to financial institutions that are trying to determine whether to approve you for a line of credit. A good habit to form is spending within your means when making purchases with your credit card to ensure you can afford your monthly payment, says Huynh. If you can’t afford to pay your bill in full, make sure you continue to at least pay your minimum monthly payment to avoid a late fee.
Keeping a low credit card balance. Credit utilization accounts for 30% of your FICO credit score and plays a role in your overall credit health. Carrying a large balance on your credit card and nearly maxing out your limit may result in a drop in your overall credit score, and lenders might view you as a potential credit risk. A good rule of thumb is to keep your credit utilization ratio under 30%.
Paying off your debt: Carrying a balance month to month can actually lower your credit score because it increases your credit utilization ratio. This is the total of all your balances divided by your total credit limit. If you have the means to pay off your credit card bill in full each month, you should do so, says Huynh. But emergencies happen, so if you have to carry a balance, at least try to make your minimum monthly payment to avoid a late payment—which can be reported in your credit history.
There is no magic formula for building credit fast, since everyone’s credit history is uniquely different. If you have no credit history, applying for a credit card and being approved will begin building your credit. It will take approximately two to three months for your on-time payments to be reflected on your credit report. But it might take nearly six months to get your first credit score.
If you have a bad credit history, it may take longer to see a dramatic change in your credit score ranging from a few months to years, depending on if you have filed for bankruptcy, foreclosure, or default in the past. But as time passes, these negative items will get older and have less of an impact on your overall score. Eventually, these entries may fall off your credit report altogether, after seven to 10 years.
A secured credit card can be beneficial for many, and it can help them achieve long-term credit goals when used properly. For the consumer who has poor or no credit history, these cards offer an introduction into healthy financial habits that can build or rebuild their credit history so they can graduate into an unsecured credit card in just months. Opting for a secured card that reports your payment history to ideally all three of the major credit bureaus will help you build your credit score.
“Regardless of whether it’s a secured or an unsecured card, it’s an opportunity for the consumer to use a credit product responsibly, which gives them an opportunity to build their credit,” says Huynh.
But there is risk involved when using any type of credit card. You have to have enough cash available to afford a security deposit to ensure the purchases made on the card. After the deposit is made, there is still a chance you may not make your monthly payments on time, and many cards charge both interest and late fees for unpaid bills. Over time, the account fees can add up and your credit score can actually decrease.
View this interactive chart on Fortune.com
Most major credit card issuers offer secured cards, but not every issuer offers the same benefits. Before applying, compare the following features to ensure it fits your credit needs:
Credit limit: The credit limit is often determined by the amount of the security deposit, which can range from a few hundred to a few thousand dollars. If you plan on making larger purchases on your credit card each month, consider looking for a card with a higher limit so you don’t max out your limit and increase your credit utilization ratio.
Annual percentage rate (APR): The APR is the yearly interest rate, stated as a percentage, that is charged by the credit card issuer to borrowers. If you fail to make your monthly payment on time, you can quickly accumulate interest fees, and the higher the rate, the more you will pay in interest.
Fees: While most secured credit cards don’t charge annual fees, some do. Other fees charged by the issuer could include late fees for missing your payment, foreign transaction fees when traveling outside the U.S., balance transfer fees, cash advance fees, or returned payment fees for failing to have sufficient funds in your bank account when paying your credit card bill.
Cardholder benefits: Not all card issuers offer benefits for secured cards, but some cards may offer reward programs for things like cash back on purchases, travel, or gift cards. Some secured credit cards may also offer benefits like a 0% introductory period on purchases and balance transfers—or it may offer a low introductory APR for a specified time period following the account opening. But be mindful of overspending in the hopes of gaining a reward.
Security deposit and account opening fees: If you are eager to start your credit building journey but don’t have excess cash on hand, consider looking for a secured credit card with a low security deposit requirement or a card that does not assess account opening fees.
“Ultimately, when you have any type of credit, the number one rule is to make sure you use it responsibly,” says Huynh. “Make sure you pay it off every month, and make sure you use it within your means. Then, over time, you gradually build up your credit history and your track record of responsible payment behavior, and that provides the building blocks for a good credit score.”
This story was originally featured on Fortune.com
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