How Does a Secured Credit Card Work?

If you're trying to rebuild credit, a secured credit card is a much better choice for your electronic payment needs than a debit card. With a secured credit card, you'll have a line of credit at least equal to your security deposit, and as you establish good credit behavior with the card, your credit score could begin to rise.

Secured credit cards 101

In most ways, secured credit cards work just like standard credit card products. They have a predetermined spending limit, an interest rate, and they are part of a major payment processing network (Visa, MasterCard, American Express, or Discover), and therefore are accepted just like standard credit cards.

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The major difference is that in order to get the card, you'll need to put up a security deposit, typically equal to the card's credit limit. In many cases, this can be as low as a few hundred dollars or as high as several thousand. This deposit is placed in an escrow account, and is used to "secure" any debts you incur on the card. If you default on your credit card debt, the issuer has this money in reserve, which can be used to settle the bill. If you pay your credit card bill as agreed, your security deposit remains in the escrow account.

Many secured credit cards allow you to request a refund of your security deposit after establishing a strong payment history, but in all cases, you have the ability to close your account and receive your deposit back, minus any money you owe on the card.

Because you're coming up with a security deposit in order to get the card, you're not considered to be particularly high risk to the credit card issuer. For this reason, secured cards tend to come with competitive annual fees and interest rates, especially when compared to other credit card products designed for people with shaky credit histories.

Advantages over debit and prepaid cards

Many people with shaky credit histories use debit cards or prepaid credit cards for their electronic payment needs. While it's understandable why people use this option -- they are accepted at most merchants and don't require a big initial deposit -- there are some major advantages to using a secured credit card instead.

To name a few:

  • Secured credit cards are reported to the three major credit bureaus, just like standard credit cards. In fact, there's no "secured" distinction when a secured card is reported. Because of this, secured credit cards can help build or rebuild your credit.
  • There are some types of merchants that want a credit card, not a debit/prepaid card. For example, it can be extremely difficult or costly to rent a car or get a hotel room without a credit card.
  • While there are exceptions, credit cards generally have better consumer protections than debit cards. In other words, if you are a victim of fraud, it can be easier to solve the problem if the fraudulent purchases were made on a credit card.

Examples of secured credit cards and what to look for

The two main things to look for when choosing a secured credit card are a reasonable annual fee and a competitive interest rate. However, be sure to consider all of a card's features before making a decision.

For example, if you get a secured credit card issued by the bank you use for your checking and savings accounts, you may be able to link your credit card to your bank account, adding an element of convenience. Another example is that some secured credit cards may offer rewards, such as cash back or airline miles.

For example, Bank of America's BankAmericard Secured Credit Card charges a $39 annual fee and has a 20.99% interest rate as of this writing, which is on the high end but not excessive. You can choose to deposit $300-$4,900 to secure the card, and one of my favorite features of the card is the ability to get your deposit returned after 12 months of good performance.

Here are a few more examples of our favorite secured credit cards.

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Matthew Frankel owns shares of American Express and Bank of America. The Motley Fool owns shares of and recommends Mastercard and Visa. The Motley Fool recommends American Express. The Motley Fool has a disclosure policy.