Secured Credit Cards
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With most credit cards, the lender issues you a credit limit they feel comfortable you can afford to spend up to, without you having to give them any money as collateral first. However, in some cases, a lender may be worried that you won’t be able to pay them back. You could have a bad credit history or, indeed, no credit history at all. If you find yourself in this situation, lenders may be able to offer you a secured credit card instead. Here’s how they work.
What are secured credit cards?
Secured credit cards are those backed by a security deposit. In order to receive a secured credit card, you have to deposit a certain amount of money with the lender. The size of the deposit is typically equal to 1-2 times the credit limit available. For example, if you want a secured credit card with a $500 limit, you’ll need to give the lender $500-$1,000 as a deposit. The deposit protects the lender in the event that you cannot pay your balance.
Who gets secured credit cards?
Newcomers to Canada are one example of the kind of people who might have to get secured credit cards. Whether they are recent immigrants, temporary residents or refugees, people in this category usually have no credit history in Canada. Banks will eventually lend on “unsecured” terms to these borrowers, but only after seeing that they can diligently pay off the balance of their secured credit card.
Young Canadians may also be ineligible for an unsecured card and have to go the secured credit card route. As with new Canadians, youth often have no credit history upon which lenders can rely.
Finally, Canadians with a history of bad credit are often steered towards secured credit cards. Credit card issuers are naturally wary of lending money to those who have not been responsible in the past, so they seek security deposits as a precautionary measure.
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Advantages of secured credit cards
The big advantage of secured credit cards is simply being able to use a credit card in the first place. Furthermore, they allow you to either build credit or repair bad credit. Think of secured cards as either first-time or remedial credit cards. It’s either a test to see if you can borrow responsibly, or a second chance at becoming a better borrower.
While you do lose the use of the money that acts as the security deposit, there is an upside. Banks will usually pay interest on your deposit, so you do make a slight return in the process. In the case of Royal Bank, they place the security deposit in a GIC for you. As such, another bonus is that your deposit should be protected by CDIC insurance (which insures up to a maximum of $100,000). Make sure your credit card issuer is CDIC-insured before setting up a secured credit card through them.
Disadvantages of secured credit cards
Of course, there are also some drawbacks to secured credit cards. First, the interest rate tends to be higher than on unsecured cards. Second, you do have to come up with the security deposit just to get the card; this means you must have the money to deposit, and you lose the use of these funds while you have the card. Secured credit cards, like most credit cards for bad credit, also tend to offer cardholders low limits (usually equal to the value of the security deposit you provide). Finally, some secured credit cards require you to pay a setup fee, which can be a small percentage of your credit limit. For example, if you’re granted a $1,000 limit but the setup fee is 3.00%, you’ll owe the bank anywhere from $1,000-$2,000 as a deposit + an additional $30 ($1,000 x 3.00%) for the setup fee.
How long do you have to use a secured credit card?
If you use your secured credit card responsibly (i.e. pay off the balance on time consistently), your lender will eventually decide to return your security deposit and grant you an unsecured card. This may take 12 to 18 months, though it depends on your prior credit history and the extent to which the card issuer feels comfortable with you as a borrower.
Secured credit cards vs. prepaid credit cards
People sometimes confuse secured credit cards with prepaid credit cards. They are similar but they operate in different ways. With a prepaid credit card, you literally “prepay” the amount you want to spend. This is done by paying a certain amount to the credit card issuer before buying anything. When you make purchases, the credit card issuer just takes the equivalent amount from the amount you deposited.
In effect, prepaid credit cards act more like debit cards, not credit cards. As you spend money, you then have to reload the card with more funds. The one key difference is that prepaid credit cards do not help you build credit.
Security deposit vs. home equity secured credit cards
Some credit cards allow you to pledge the equity in your house as collateral for a secured credit card. For example, the Home Trust EquityLine VISA card permits people to borrow up to $100,000 against their house’s equity. While tempting, these cards should be treated with caution. House prices can go down and as such, the equity in your house could also decline.
Using one of these cards may not be the best way to borrow against your house’s equity. A traditional home equity line of credit (HELOC) offers substantially better interest rates than a home equity secured card. It would only make sense to use one of these cards if you do not qualify for a HELOC, either because you have less than 20% equity in your house or no income. And if you have little equity in your house as-is and no income, a home equity secured card is a very risky financial decision.
A way to start or a chance to rebuild
If you’re looking at a secured credit card, chances are you don’t qualify for an unsecured one, either because you have bad credit history or no credit history at all. It might not be ideal, but secured credit cards do offer the possibility of building a credit history, or repairing a less than stellar one. And if you use it responsibly, you should be able to graduate to a more traditional unsecured card.