Access to credit is nearly essential in the modern age. Despite the advice of some popular commentators, building a record of regular and responsible use of consumer credit is important since it impacts more than just the ability to obtain a loan.
Credit scores are used by landlords, insurance companies and even prospective employers, and a solid history can open many doors aside from merely borrowing money.
Yet it is also easy to fall into a downward spiral of increasing debt that may lead to delinquencies or even insolvency, whether by lack or experience or due to setbacks like a job loss or medical bills that can lead to serious damage to a borrower’s credit score. For folks like this seeking a fresh start, or for younger consumers with little or no credit history of their own, a secured credit card account can be an excellent tool for building or rebuilding a solid credit foundation.
A secured credit card looks and works just like a regular Visa, MasterCard or Discover card that can be used to make purchases in the same way, either in person or online. When using the card, the holder borrows the funds from the issuing bank, receives an account statement each month, and must then pay the balance due monthly. Just like regular cards, secured accounts incur no interest as long as the entire balance is paid in full by the due date. The fundamental difference is the requirement for the holder of a secured card to post collateral in advance.
Although no one is entirely certain who came up with the idea, industry lore traces the origin of secured credit cards to a handful of San Francisco Bay Area credit unions in the late 1970s. By 1981, seven credit unions banded together to issue secured credit cards carrying the Visa brand that required posting collateral in a savings account at the institution. These early products carried a credit limit of between 50% and 80% of the collateral deposited.
Throughout the late 1980s, the segment suffered reputational damage from some unscrupulous early “credit repair” agencies. Only about 50 banks in the U.S. issued secured cards, making it difficult for many consumers to obtain approval, giving rise to a class of firms that acted as third-party brokers and sometimes called themselves “credit repair companies.”
Many of these firms collected upfront fees or deposits from customers to open prepaid credit accounts but never successfully delivered a card. In response, Visa and MasterCard implemented more rigorous oversight, requiring card issuers to register and qualify for approval before issuing cards under their respective nameplates.
These reforms, along with federal regulatory oversight and congressional legislation in the early 2000s, effectively restored confidence in the prepaid card market, which grew robustly between 2010 and 2021. According to the Philadelphia Fed, there are 3.7 million secured accounts today, roughly 2% of all credit cards.
Interestingly, the popularity of secured credit cards has declined since 2021 as new financial technology applications like credit builder loans as well as reporting of rent and utility bills have provided additional avenues for improving a consumer’s credit history. Still, the secured card can be a valuable tool, especially for certain transactions that require a credit card like car rentals, and for building muscle memory in regular credit management.
Secured credit card issuers report to the recognized credit agencies, helping to establish a history of responsible use. They are also subject to the same fraud protection as conventional credit cards, limiting liability to $50 if the breach is reported promptly (and if the prepaid card has been registered with the issuer).
Just like with traditional cards, secured credit cards come with hefty interest rates for those who carry a balance. Rates are keyed off the prime rate plus a substantial premium to offset risk to the lender, with most now charging an annual percentage rate of 25% or more.
Of course, failing to fully pay the balance each month defeats the entire purpose of the exercise. On a positive note, over the past 10 years most issuers have eliminated any annual fees. And just like traditional cards, these secured accounts are increasingly offering rewards programs, typically a small percentage of cash back each month if paid promptly.
Moving from a secured card to a standard unsecured credit cards account is referred to as graduation. Issuers generally begin reviewing borrower history after a few months, and on average, about 20% of customers receive a refund of their deposit and transition within one year with an improved score and a fresh start.
Features and expenses vary, so it pays to search diligently for the right option. Good sources of information include NerdWallet.com, Bankrate.com and Creditcards.com, where you can read more about each offer and compare costs. Look for an issuer that reports to all three credit bureaus (Experian, TransUnion and Equifax), has a manageable collateral deposit amount and doesn’t carry additional fees.
Particularly for individuals with little or no history, referred to as having a “thin” credit file, and for those who have taken a few lumps and have dented record, a secured card can be an excellent option for getting a leg up in the modern cashless society. Credit is a tool, and good credit can be invaluable.
Christopher A. Hopkins, CFA, is co-founder of Apogee Wealth Partners, LLC.
