Just like bank loans, where there is secured and unsecured borrowing by businesses, credit cards as a form of consumer debt can also be either secured or unsecured.
Credit cards, as most of us know and use, are unsecured.
The money is lent to card users without any collateral against it and it is up to consumers to pay back the account balance later and if not, the card issuer loses (well, they will go after you but there is no guarantee they get their money back). When the possibility of not paying back by a credit card holder becomes a serious concern, either because of the applicant’s bad credit in the past or no established credit at all, a card issuer would require certain amount of funds to be deposited as collateral before a credit line can be issued.
The potential card holder must first open a savings account (or a CD), 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.
Basically, you are giving the credit card company money of yours to hold. This money is like insurance for them in case you don’t pay your credit card bill. If you don’t pay they at least have your money.
Why Do Secured Credit Cards Exist?
Even though some consumers are cutting back on credit card use to reduce debt and are turning to debit cards or simply paying cash, credit cards cannot be replaced as long as current consumer credit reporting system remains in place.
Consumer credit rating (your credit score) relies heavily on consumer credit card data that are submitted by credit card issuers and analyzed by the three credit card bureaus. Without credit cards and the data collected about how they are used, a consumer’s credit worthiness is much more difficult to be determined. Most will need to use a credit card if they wish to build a credit history or repair past credit.
Credit cards, secured or unsecured, can be used for that simple reason. But for some people, a secured credit card is the only solution.
Who Needs a Secured Credit Card?
Starting with no credit history or a bad credit history makes it hard to apply for a regular, unsecured credit card (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).
However, 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. I can think of so many people who got their first credit card (unsecured) and went wild with their new credit, quickly using up their credit limit.
If you do decide to get a secured card (if you need one to build credit trust), remember the goal is to build up your credit quickly so you can move to an unsecured card and get your collateral deposit back. Also look into cards that have little or low fees, shop around for the lowest APR you can find, and make sure you understand the details of where your collateral money is going and what it takes to get it back.
Remember, the point is to develop GOOD credit habits so you really need to make sure you pay back your card on time and, hopefully, in full!