“Why would you borrow money for something you could buy outright?”
I heard this question a lot when I was a young ensign in the Navy. I had set up a credit building loan with the credit union. The very nice loan officer had taken the time to explain that if I built my credit now – when I didn’t need it, I would be able to get financing and the best possible loan rate when I was ready to buy a house or make any type of major purchase.
The advice I got that day has paid off in spades. Thirty years later, after having bought two houses, refinanced multiple times, and made too many major purchases to count, the money I’ve saved in interest dwarfs the small amount of interest I paid to establish my credit. Nowadays, you can build your credit without spending a dime in interest by setting up a secured credit card. But secured credit cards are not all the same.
“Many third party institutions offer secured cards with fees or other pitfalls,” says Scott Post, SVP of Strategy and Delivery at Hanscom FCU. “A good financial institution will make it as easy as possible to get you on the road to good financial health.”
What is a Secured Credit Card?
When you borrow money, the lender reports how you manage your payments to one or more of the three major U.S. consumer credit reporting agencies: Experian, Equifax, and TransUnion. These companies keep track of all the information on your credit report. Future lenders can then look at your report to help make a decision on whether to lend to you.
The term “secured” simply means that you have collateral behind a loan. If you borrow money for a mortgage or home equity, your house is the collateral. If you borrow money for a car, the car is the collateral. If you fail to make your payments, the lender can take possession of the collateral to satisfy the debt.
With a secured credit card, the amount of your credit line is secured against funds in your share savings account. For example, if you secure $500 in your savings account, you can then borrow up to $500 on your credit card. Note: Never charge more than 33% of your credit line. So if you want to actually borrow $500, secure $1,500 in savings. The purchases made with the card and paid on time are reported to the credit bureaus that in turn begin building your credit history.
Once you’ve consistently shown that you make your payments on time, the lending institution will unsecure the card and you’ll be free to access the savings account. Typically, this takes six months to a year and is subject to normal underwriting factors.
What is the difference between a secured credit card and a prepaid debit card?
Although the two cards may seem similar and both have a Visa or MasterCard logo, they are really quite different. A prepaid debit card is “loaded” with your money. It is a means of spending your money with a debit card. You are not borrowing money and thus not building your credit.
With a secured credit card, you are borrowing the money. If you pay the balance in full each month, there are no interest charges. If you carry a balance, you will accrue interest. Ideally, you pay the balance in full each month and build your credit while not paying interest. All the while, you are establishing a history of borrowing and making payments on time.
Best practices for building credit
- As you start out on the road to building credit, use your credit card sparingly, make only a few small purchases each month and make sure to pay them in full. Never charge more than 33% of your credit limit.
- Learn how to read your credit report and know your credit score. If you have no credit history, you will have an empty credit report. As you use your new card and then go on to borrow for a car or house, your credit report will grow. Think how much easier it is to learn to read your credit report while it is relatively simple versus trying to figure it out on the fly if you you’ve gotten into credit trouble.
- Regularly keep an eye on your credit report and deal with any issues immediately. Our members can get their credit reports and score free once a year. Also, you can get a credit report from each of the three major credit bureaus at annualcreditreport.com.
“Don’t just get a credit card and hope for the best,” says Post. “Have a plan for your card and how you will build your credit. Set up alerts or auto payments on the card to make sure you pay on time. And regularly monitor your credit report to make it is correct and that everything is correct.”
Bottom line – establish your credit early in life, manage it wisely and it will serve you well.