What is a secured credit card and how does it work?

When your FICO credit score is in the lowest range — 579 or below — finding a credit card issuer who will approve you for one of its products can seem like an impossible feat. Fortunately, card issuers offer one type of credit card that almost anyone can be approved for.

With a secured credit card, consumers with poor credit get the chance to build credit, practice good credit card habits and prove their creditworthiness over time. This form of credit requires a cash deposit to secure a line of credit. However, despite having to pay a deposit, secured credit cards function like traditional credit cards when it comes to making purchases and payments.

What is a secured credit card?

Getting approved for an unsecured credit card can be difficult when your credit score is poor, yet you may not be able to improve your credit over time if you can’t find a lender to give you a line of revolving credit. You can still build credit without a credit card, but you can’t get approved for a credit card without having an established credit score. That is where secured credit cards come in.

A secured credit card is a type of credit card that is backed by a cash deposit. The deposit is often equal to the credit limit, which tends to be equal to 50 percent to 100 percent of the amount of the initial deposit. Typically you’ll find that the credit limit matches your security deposit by 100 percent though. So if you put down a security deposit of $500 then you would be able to spend up to $500 on your secured credit card.

How do secured credit cards work?

A secured credit card functions similarly to a debit card. However, you’re essentially relying on your cash deposit, which is what translates to your secured line of credit to make purchases.

To get a secured credit card, you can apply for one at a bank, credit union or credit card company. The financial institution you’re working with may check your credit history during the approval process.

The credit card provider should report information about your account to the three main credit bureaus — Experian, Equifax and TransUnion — which can help you increase your credit score, assuming you use your card responsibly. Remember to double-check with the issuing company before you apply to make sure it will report your payment history to the three main credit bureaus.

If approved, you’ll need to make a deposit that acts as collateral. So if you don’t repay the credit card balance, the card issuer will seize that deposit to cover what you owe. This is often at least $50 and can be as high as $2,000 to $3,000. Your deposit amount will also act as your credit limit, although your limit may also be less than the deposit amount.

After making the initial deposit, you can use the card to make purchases in-person or online up to your credit limit. A secured credit card can be used in places where credit cards are accepted like gas stations or grocery stores. Once you pay off your balance for any recent purchases, you can then use the card again to make more purchases. If you don’t pay off your balance in full each month, you will start to incur interest on the carried balance.

When should you get a secured credit card?

Consumers often use secured credit cards as a way to build their credit scores either because of a rocky financial past or simply because they have no credit history. Whichever situation applies to you, let’s take a further look at when it may be the right time to consider one of the best secured credit cards.

You want to build your credit

Secured credit cards provide cardholders with a small line of credit in exchange for a refundable deposit that is put down as collateral. If you have poor credit or no credit at all, lenders see you as a liability because you have no credit history to prove what kind of borrower you are. However, by putting down a security deposit, the lender mitigates some of the risk in the case you default on your payments.

However, like any credit card, building credit is all about how you use the credit you have access to in the first place. If you can manage to keep your credit utilization low and make on-time payments every month, your credit score will improve in no time.

You want to graduate to an unsecured credit card

Secured credit cards make it easy to graduate to an unsecured credit card once you’ve successfully worked on your credit score.

Your issuer may upgrade you to an unsecured credit card once you prove your creditworthiness with on-time payments, or you can ask your credit card issuer to transfer your secured line of credit to an unsecured credit card. This may take around 12 to 18 months, depending on how well you manage payments and build your credit score.

Alternatively, you could apply for a new unsecured credit card while holding on to the secured credit card account. Closing a credit card can actually hurt your credit score because you are reducing the total amount of credit you have access to in the first place. However, keep in mind when you close your secured credit card account, that is typically when you’ll get your full deposit back.

Tips for using a secured credit card

The same rules apply to secured credit cards as they do to unsecured cards. Here are a few recommendations to keep your score in the best shape possible:

• Always pay your balance on time. On-time payments are the single most important factor when it comes to calculating your credit score, accounting for 35 percent of your overall score. You want to aim to pay your statement balance in full every month to avoid interest and keep your credit in good standing. If you can’t make the full payment, don’t fret, but always make at least the minimum payment on time.
• Confirm that the bank reports to the three main bureaus. If you are using a secured credit card in order to improve your credit score, you’ll want to ensure the credit card provider is reporting your credit usage to the three main credit bureaus. Some issuers may not report the status of secured cards, so make sure you are applying for a secured card that reports to at least one of the credit bureaus if better credit is your goal.
• Keep your credit utilization rate below 30 percent. Credit utilization refers to the total amount of available credit you’re currently using in relation to the total amount of credit you have access to. Generally, it is best to keep your credit utilization below 30 percent. A high credit utilization means you’re close to maxing out your credit card and this can ultimately hurt your credit score.
• Don’t overspend. The key to using a secured credit card is to use it for a few fixed purchases each month so it is harder to reach your credit limit. This will help you learn financial discipline while also building a strong credit score. When you are searching for a secured credit card, try to avoid committing to a deposit that will get you in financial trouble. Just because you have access to a $1,000 credit limit doesn’t mean you should max out your card the minute you get it.

The bottom line

Secured credit cards may be the way to go if you’ve never had a credit card or want to improve your credit score. Building credit with a secured credit card is a great way to get your finances on track by establishing strong financial habits. This requires a bit of discipline as you learn the do’s and don’ts of credit, but when you put in the work, you will be on track to upgrading to an unsecured credit card in no time.