In the world of credit, there are unsecured loans and secured loans. Traditional credit cards are unsecured loans (and cards) have no collatoral (item of value) attached to them. The loan is offered based on the borrowers past history of payment (and the interest rates and available credit are also adjusted based on your past history). The credit card company takes a risk of not being repaid and having no item they can repossess that can be used to repay the outstanding debt. They can send your account to collections and damage your credit report, but there is no guarantee they will be repaid.
For people who may not be eligible for a traditional card for one reason or another, a secured card may be a great way to establish repayment history. The issuer has full guarantee of repayment as the credit line is limited to the amount that is deposited into a reserve account.
In order to establish a secured credit account you must first open a savings account, also known as collateral account, with a card issuer for an initial amount from $300 or $500 up to $5,000 or $10,000. The credit line can be equal to the amount deposited or at a percentage of it. As purchases are made on the card, the funds are not deducted from the account and the funds will stay in the collateral account as long as the card holder makes monthly payments for at least the minimum amount. Some credit card issuers may pay interest on the deposits.
Like regular credit cards, purchases are billed every month and there will be interest charge on any outstanding balances after each grace period. Many secured credit cards may require an annual fee and one-time setup fee. A secured credit card functions like any other credit cards and there is no difference in the appearance of a secured credit card and a regular one.
Who Needs a Secured Credit Card?
If you are establishing credit and don't have a payment history listed on your credit report to begin with, a secured credit card can be helpful in establishing that record of payments (think about it, why would a credit company want to loan money to someone that hasn’t proven they can pay OR hasn’t paid in the past). Applying for a secured credit card can be easy and fast when personal funds are used to guarantee the repayment of future credit card bills. Because a secured credit card works the same way as a regular credit card in terms of using it for purchases and paying monthly card bills, over time the card holder can establish a positive pattern of card uses by paying back on time. Ultimately, the data collected by the card issuer is reported to credit card bureaus and good credit will be reflected in the credit report (and in turn will raise your credit score). Moreover, after a certain period of time, such as a year, based on the card holder’s responsible use of the secured credit card, the card issuer may switch to issuing a regular, unsecured credit card.
A secured credit card certainly isn’t for everybody. But it can be a great tool to help establish credit or develop good credit habits. I’ve even wondered if it’s not one of the better ways for a person to first get a card. Think of it, if you know you’re money is on the line you will have a great incentive to develop good spending and paying habits. Since your money is on the line, you are less likely to engage in impulsive spending choices.
Have any of our savers tried the secured credit cards? If so, let us hear from you!
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