Secured vs Unsecured Credit
Secured credit is a great option for people with bad credit who need to borrow money. It’s also ideal for those without any credit history and trying to build credit for the first time. But what is secured credit and how does it work?
What is secured credit?
Good credit is important for your financial stability and long-term success. However, if you haven’t used credit before or have gotten into financial trouble that has damaged your credit, convincing a lender to give you a chance can be challenging. You need credit to get credit. It’s a tough situation.
Secured credit is any loan or line of credit that requires collateral, items of value like real estate, vehicles, stocks and bonds, cash, or other belongings, with a value that’s comparable to the amount borrowed. It’s a security measure: if a borrower doesn’t repay what they owe the lender gets to keep the collateral. By contrast, loans or credit cards that don’t require collateral are known as unsecured credit.
Some of the most common types of secured credit include mortgages and auto loans. When you borrow money from the bank to buy property, the property itself is the collateral; fall behind on your mortgage and the bank will foreclose on your home. Finance a new vehicle but don’t make payments? Your car will be repossessed and brought back to the dealership. Pawn shops are another common source of secured credit, and loan borrowers money based on the value of the personal belongings like jewelry, technology, or furniture offered as collateral.
All of these loans are backed or secured by an object with a value equal to the amount borrowed. However, collateral isn’t only used for loans. It can also be used to open a line of revolving credit known as a secured credit card, often referred to simply as a secured card.
One of the biggest distinctions between different types of credit is whether it is secured or unsecured. These two types of credit have major differences in eligibility requirements, cost to use, and how they play into your larger financial strategy.
The difference between secured and unsecured credit cards
With a secured credit card, a cash deposit is used to determine your credit limit rather than your credit history. If you were to put down $500 in collateral, you’d have a $500 credit limit.
Traditional credit cards that most people think are the unsecured types. These do not have property or other assets attached to the amount someone borrows — convenient for borrowers, but risky for unsecured credit card issuers. For this reason, unsecured credit cards are usually more difficult to qualify for, requiring having at least some prior credit history.
If you don’t repay what you borrow on an unsecured credit card, you’ll get hit with fines, fees, and damage to your credit score. Your credit card lender can’t seize any of your property outright. They may be able to place a lien on your home, but only after a judge’s ruling.
Failing to make payments on a secured credit card can also result in fees and negative credit remarks. However, you also run the risk of losing your initial deposit (collateral).
Secured credit cards are a stepping stone to unsecured credit. If you can’t qualify for an unsecured credit card, consider opening a secured credit card account and using it for at least six months to a year. This will help you build a positive payment history so you can get approved for an unsecured credit card once you’ve had some time to improve your credit score.
Aren’t all credit cards unsecured?
No. Although the type of cards we traditionally think of when we think of credit cards are unsecured – the kind where you apply for a card, then the creditor offers you a certain credit limit and rate based on your creditworthiness and credit score – there are actually other credit cards called secured credit cards.
If you’ve used credit before and have a decent credit profile then your credit cards are likely to be all unsecured. However, if you’ve never used credit before or don’t have a good credit score then you may not be able to get approved for unsecured credit cards.
What to expect when opening a secured card
Even though secured cards operate based on a cash deposit as collateral, you still have to apply for the card (which can usually be done online like any other credit card application). Once approved, you’ll be prompted to put down a security deposit to establsih your credit line. Be mindful of the mininmum deposit required.
In most cases, your credit line will be equal the amount of your deposit. In some cases, secured credit cards may give you a little extra credit line in addition to the deposit. If you put down $300, you could get a $500 credit line. The deposit can usually be paid directly from your bank account. Note, it cannot be used towards your monthly payments or to cover other fees. It’s only purpose is to secure your credit line. Only charge what you can afford to pay off in full every month.
Continue using your secured card responsibly and you may find your credit line is increased without any additional deposit. Keep it up long enough and you may even recieve an invitation to upgrade to the unsecured version of your credit card.
Aside from this, most secured credit cards work identically to unsecured cards:
- Both offer liablity protection in case of fraudulent purchases
- Both can be used for online purchases
- Both can be used for tap-to-pay or chip payments.
Making monthly payments on a secured card works largely the same way too. How much you owe each month is based on how much you’ve charged and will vary as your balance goes up and down over time.
Typically after 6 months of on-time payments, you should see an improvement in your credit score. Once you have achieved at least a fair credit score, most creditors will begin to offer and approve you for unsecured credit cards that don’t require a deposit.
If you choose to close the secured account, the credit issuer will refund your deposit as long as you’ve made all payments on time. If you allow the account to default, you will lose your deposit.
Tips for using secured credit cards
While secured credit cards differ depending on the card and credit issuer, the following general rules can help you use the account to your best advantage:
- Be careful with annual fees – these can make certain cards more expensive to use on a yearly basis.
- Opt for low interest – this way, if you ever have a month where you can’t pay off the balance in full, you don’t end up running up the debt with added interest charges.
- Be wary of secured reward cards – in rare cases, you may find a secured credit card with a rewards program included, but whether you’re new to credit or you’ve had trouble in the past, earning rewards while you manage the debt effectively is a more advanced credit strategy. It’s often better left for when you’re more comfortable using credit. Additionally, rewards credit cards tend to have higher interest rates.
- Make sure the issuer reports to all three bureaus – this way you ensure you’re building credit effectively with the credit bureaus that maintain the profiles used by lenders.
- Make sure the deposit is fully refundable – in most cases, you should be able to pay off your balance and receive your full deposit back.
- Opt for credit tracking if it’s available – some issuers offer free credit score tracking or credit monitoring when you open an account. This can give you a big edge as you work to build credit.
Unsecured debt offers several distinct advantages over its secured counterpart – especially when it comes to open-ended revolving credit lines like credit cards. The only trick comes in knowing how unsecured debt works, what it means for your bottom line, and how to manage it effectively to avoid potential problems that can lead to financial distress.
