by Claire Tsosie
Using a secured credit card is like being in high school: you have some freedom, but you're counting the days until you can graduate to something better. With costly deposits, low credit limits, annual fees, high interest rates and minimal rewards, secured credit cards usually aren't great for shopping, but they can help you establish a good credit history and work your way into some better terms.
Secured credit card basics
A secured credit card is easier to qualify for than a regular -- or unsecured -- credit card. With this type of card, you'll have to pay a deposit as a form of collateral to cover the issuer's losses if you default. You don't draw on the deposit when you use the card, so you'll need to make monthly payments just as you would with an unsecured card. You'll be able to get this deposit returned to you after you upgrade or close your card, so long as you stay current on your payments.
The issuer then extends a line of credit to you, often matching the same amount of money you've provided for the deposit. For example, if you deposited $500, you would typically get a $500 credit limit. Many secured cards also report to the three major consumer credit bureaus, which allows you to build credit. This is a major difference between secured cards and prepaid debit cards, which won't do anything to improve your credit score.
Make building credit a priority
Just as you probably don't want to stay in high school forever, there's a good chance you don't want to hold onto your secured credit card for the rest of your life, either. Even the best secured cards don't offer much spending flexibility, and most are expensive to maintain. Instead, you're looking for a credit card you can use as a stepping-stone to get an unsecured credit card.
Because of this, it's important to look for a secured credit card that will report your payments to the three major consumer credit bureaus, TransUnion, Experian and Equifax. If you get a card that doesn't report to these bureaus, it won't help you improve your credit, and your on-time payments won't make it easier to get an unsecured card.
As of March 2016, all of the secured credit cards listed on NerdWallet's credit cards tool report to the three major credit bureaus. If you're not sure whether your secured credit card reports, call the company and ask. This way, you'll know whether your on-time monthly payments are counting toward your credit reports and credit scores.
For now, rewards aren't that important
Sure, it's tempting to look for a secured card with the best rewards, but when you have a secured credit card, that probably shouldn't be your top concern. Getting 1% cash back on your purchases may sound enticing, but if you have a $300 credit limit on a secured card, that 1% makes almost no difference. Your credit score may also suffer if you get too close to that limit, making it difficult to qualify for unsecured credit cards with larger rewards in the future. Here's what you may want to look for instead:
- A grace period. Not all secured credit cards have grace periods, or set amounts of time when interest does not accrue. If your card doesn't have this time window (often around 25 days), you may end up shelling out a lot more in interest, even if you pay in full every month, especially if it already has a high annual percentage rate, as many secured cards do.
- An easy way to upgrade. Some credit card issuers offer programs that upgrade you to an unsecured card after 12 to 18 months of responsible credit use. Because closing your secured card could lower the average age of your credit accounts and ding your credit score, finding a card that upgrades could be a smart way to continue building your credit while gaining better terms. If you have bankruptcies, tax liens or other serious, negative information on your report, it may be a little tougher to upgrade to an unsecured card. Be patient, and keep making those on-time payments.
- A bank you have an account with. If you can get upgraded to an unsecured card with the bank where you have a checking account, you may be able to get additional benefits from being a cardholder -- and you won't have to close your account to get your deposit back.
Once you have your card, focus on staying below the limit and paying off your balance in full every month. If you start with no credit, it may take as little as six months to build up enough good history to get approved by another issuer for an unsecured credit card, if you don't want to wait for an upgrade from your original issuer. If you have bad credit, it will likely take longer.
When it comes down to it, the earlier you establish these good borrowing habits, the sooner you'll be able to boost your credit. And once you're ready to graduate to an unsecured card, all of your efforts will be worth it.
Claire Tsosie is a staff writer covering personal finance for NerdWallet. Follow her on Twitter @ideclaire7 and on Google+.