Secured credit cards can help people with bad credit or short credit histories escape this paradox. Here’s what you need to know to understand secured cards and how they differ from unsecured cards.
Secured vs. unsecured
A “secured” loan is one that has collateral behind it. A home mortgage, for example, is secured by the home. If the borrower doesn’t make the payments, the lender can take the home.
Most credit cards are unsecured loans. You borrow money to make purchases, then pay some or all of that money back each month, with no collateral involved in the deal. Because of that, you typically need at least average credit to qualify for an unsecured card, and the best ones require good or excellent credit.
There are a few unsecured credit cards that advertise themselves as easy to qualify for even if you have bad credit. But these cards often come with extremely high fees. That’s why NerdWallet usually recommends applying for a secured credit card rather than opening a high-fee unsecured card.
Secured credit cards
With a secured credit card, your line of credit is secured by a deposit you make with the bank issuing your card. That deposit is refundable, meaning you get it back later. Your credit limit is usually (but not always) equal to the size of your deposit. So if you deposit $300, you’ll have a credit limit of $300. The minimum and maximum amount you can deposit varies by issuer. Ideally, you’ll improve your credit enough to move to an unsecured card, at which time you can close the secured account or convert it to unsecured, and the issuer will give you back your deposit.
The deposit protects the card issuer in case the cardholder defaults on the debt. That substantially reduces the risk to the issuer, which is why issuers are willing to provide secured credit cards to people with bad credit. But keep in mind that the issuer will tap the deposit only if you don’t pay your bills. You don’t “load money onto the card” like you do with a prepaid card and then use that money to make purchases. When you use a secured card, you are borrowing money with each purchase — just like with an unsecured card.
Once the initial deposit is paid, secured cards work just like unsecured ones. You can use them wherever credit cards are accepted, including online, and you incur interest if you carry a balance. Many large credit card issuers offer both secured credit cards and unsecured cards, and it’s reasonable to expect your secured card to carry an annual fee of no more than $50. Several good cards are available with a $0 annual fee.
Prepaid debit cards
Prepaid debit cards seem similar to secured credit cards. You have to put up money before you can use the card, and they typically have a Visa, MasterCard or American Express logo.
But with prepaid debit cards, you’re using your own money to make purchases — not money borrowed from the issuer. Since these cards don’t extend you any credit, account activity isn’t reported to the credit bureaus. Therefore, you’re not building a credit history by using the card. If building credit is your goal, a secured credit card is really your best bet.
Using your new secured card
Although they require a deposit, secured credit cards are a powerful tool for rebuilding credit. You can make the most of the opportunity by using them sparingly, making only one or two small purchases every month and paying the balance in full before the due date. If you pay the balance in full each month, you won’t be charged interest — which is good, because secured cards tend to have higher annual percentage rates than unsecured cards.
Many people find that by using a secured card carefully, it takes only about a year to improve their credit score enough that they’re able to qualify for an unsecured card. Some issuers will let you transfer your secured line of credit to an unsecured one, which is better for your credit score because it doesn’t require you to open a new account.
But even if you do have to apply for a new unsecured credit card, you may be able to enjoy some of the benefits of having good credit — lower interest, rewards and more competitive fees. When that day comes, your time rebuilding your credit with a secured credit card will have been worth it.
Updated Oct. 25, 2016.