It's somewhat like a debit card, but it builds credit. It works like a credit card — you can book a hotel or rent a car — and yet, you deposit cash before you can use it. Get to know how secured credit cards work and why they might be right for you.

If you have bad credit (or no credit at all), you may find it difficult to get approved for a traditional unsecured credit card.

The best credit cards offering rewards and/or 0 percent APRs require excellent credit. To many consumers’ surprise, “excellent credit” typically means a credit score of 720 or higher and at least five years of credit history without late payments or other derogatory marks. Although there are many good credit cards available to consumers with good-but-not-perfect credit, there’s a steep drop off for applicants with credit problems or—even worse—no credit it all.

That’s where secured credit cards come in.

To rebuild credit wrecked by bad planning or unexpected financial crises, or to establish credit for the first time, a secured credit card can be a good place to start.

Here, let’s talk about what they are, how secured credit cards work, and who they’re for.

What is a secured credit card?

A secured credit card looks and works just like a credit card. You can use it pump gas, leave tips, rent a car or book a hotel.

You’ll receive a monthly statement and must make a monthly payment on your account. If you do not pay your bill in full, you’ll pay interest on the unpaid balance. Finally, the bank reports your payment history to the credit bureaus, meaning that every month you pay your secured credit card bill, you’re building credit.

A secured credit card requires a deposit

With a traditional credit card, the bank lets you make charges and trusts you will repay them later.

With a secured credit card, the bank requires you to put down a cash deposit before you can make charges. That deposit becomes your credit limit.

For example, if you get a card with a $500 credit limit, you’ll need to put a deposit of $500 down before you can use your card. You can then make up to $500 in charges on the card.

Your deposit is collateral on the credit card

Another way to think about a secured credit card is it’s like a loan that requires collateral. When you have a mortgage, your home is the bank’s collateral. If you don’t pay, the bank can foreclose on your home to recoup the money they lent you. Your home secures the loan.

Most credit cards are unsecured debt, meaning there is no collateral. Unsecured credit products are riskier for banks which, in part, explains why the interest rates on credit cards are so high. With a secured credit card, however, your cash deposit is your collateral. If you fail to pay your account, the bank simply claims the money you deposited.

Why secured credit cards are not the same as prepaid debit cards

It’s easy to confuse secured credit cards with prepaid cards or even traditional debit cards. With all three products, you must put money into an account before you can use the cards. The primary differences between a secured credit card and debit cards (whether prepaid or linked to a checking account) are:

  • Charges on a secured credit card do not draw down your deposit balance
  • Secured credit cards require monthly payments
  • Unpaid balances on secured credit cards will accrue interest
  • Secured credit cards help you build credit; debit and prepaid cards do not

Why get a secured credit card?

If you have bad credit, getting a secured credit card is arguably the best way to improve it without a cosigner or resorting to another credit product with exorbitant interest rates and fees.

A secured credit card is also useful for someone with no credit history.

For students or recent graduates who’ve never had credit accounts, a secured card can be an important first step. Just like a traditional credit card, secured credit cards can be used to build credit—by putting purchases on the card and making timely payments.

A secured credit card is easier to qualify for because lenders do not need to determine whether you’re creditworthy to issue you a card. Since applicants provide collateral equal to the credit limit, the lender assumes no risk. If you don’t pay your bill, the lender has the collateral (i.e. the deposit) to cover what you owe. Someone with poor credit can access a secured credit card when traditional cards are unavailable to them. And, by making timely payments, they can improve their credit enough to qualify for unsecured cards, that come with higher credit limits and rewards.

The downside to secured credit cards

Like a traditional credit card, a secured credit card charges fees and sometimes high interest rates. It is in your best interest to shop around to find the card that offers the best deal. You shouldn’t ever have to pay an annual fee of more than $50 for a secured credit card. And you should run, not walk, away from cards that want to charge you application fees, processing fees, or anything like that.

Check out the no-annual fee Capital One Secured Mastercard or the Discover it® Secured. Both require a minimum $200 deposit.

When shopping for secured credit cards, read the fine print carefully because there may also be additional fees for transactions, like ATM withdrawals. Like any credit card, secured or not, you should read the fine print to make sure you know what you’re getting—and what you’ll pay for.

It’s important to remember that you can still get yourself further into debt with a secured credit card. For example, if you have a $500 limit on your secured credit card with an 18-percent interest rate, and you only pay the minimum balance every month, the interest will compound and you will owe more money. If you stop paying the card all together, you will have fees to pay, too. Even though the card is secured with your deposit, you can still be charged additional fees and interest with a secured credit card. If you’re still having trouble controlling your spending, wait before you get another credit card—even a secured one!

Summary

If you need to build or rebuild your credit (whether it’s because you made mistakes in the past or because you have never had credit), a secured credit card may be your best option.

With a secured credit card, you make a deposit equal to your credit limit as collateral. The lender issues you a secured credit card that you can use like a traditional, unsecured credit card, up to your limit. The lender avoids risk and you are able to build a solid record of on-time payments.

With a secured credit card you may be on your way to better credit—just be careful to pay attention to additional fees and interest rates.

Recommended: The best secured credit cards

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About the author

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Natalie Bacon is the blogger behind Financegirl, where she writes about finance and intentional living for young professional women. Natalie is a former corporate attorney who traded in her job to pursue a career in financial planning, freelance writing, and blogging.