When you are first starting out building your credit, you may find that you keep running into rejections for credit cards or other lines of credit because you lack credit history. If you already have established credit, you may have run into some financial hardships and ended up with a low credit score, which prevents you from getting approved for credit lines that will help improve your score. While this can become frustrating, there are options out there for you!
The two most common options for those with low scores or limited history are secured credit cards and credit builder loans. While they function in different ways, their purposes are similar: to help those who can’t get approved for traditional lines of credit. Before choosing one of these options, it’s important to know how they work and how they differ from each other.
When you think of credit cards, you are likely thinking of an unsecured type of card. These are the most common types of credit cards out there. Unsecured credit cards don’t require any form of collateral. The bank is basically taking you at your word that you will pay them back the money you are borrowing from them.
For this reason, banks become hesitant to give those with little credit or bad credit an unsecured credit card because they aren’t sure they’ll get their payments.
How Do Secured Credit Cards Work?
Enter secured credit cards. These are cards that many banks won’t even check your credit report for. Instead, they consider items like your income, and they require that you make a refundable down payment when opening the card. The amount required for the down payment will likely vary based on the bank you go to, but that amount is usually equal to the credit line that you receive with the card.
The deposit you make acts as collateral on the credit card. If you fail to make the payments required, then you won’t receive your deposit back. However, if you continuously show good money handling skills, you may receive an increase in your credit line without needing to make a bigger deposit.
How to Use a Secured Credit Card
As far as using the credit card, it works very similarly to unsecured cards. You’re able to make purchases up to your credit limit and pay the money back each month when your statement is due. Each statement will have a minimum payment that you must pay, but it’s suggested you pay off the full balance every month.
It’s important to note that many secured credit cards will charge an annual fee in addition to the deposit you have to make when you open them. However, these cards are meant to be a stepping stone in your credit-building journey.
Once you have a good record of using the card and you’ve seen improvement in your credit score, many banking institutions will upgrade your account to an unsecured line of credit and give you your initial deposit back. If they do not offer any upgrades, you may want to think about opening an unsecured line of credit elsewhere.
When you take out a traditional installment loan, you are typically given the full sum of the loan amount at the time that you take the loan out. You then are required to make payments on the loan until it is paid off completely, including any interest that comes along with the loan.
How Do Credit Builder Loans Work?
Credit builder loans work differently than installment loans. Instead of giving you the whole amount at one time, the bank you get your credit builder loan through will put aside a small amount of money into an account that they have control over. You then make installment payments for a determined amount of time (usually between six and 24 months). Once you’ve made your final payment, the bank will give you the money they set aside for you.
It’s important to remember that these loans do accrue interest while they’re being paid off, and you’re paying that amount in addition to the loan amount. There also may be different fees that you have to pay when you open the loan, depending on the bank’s requirements.
With credit builder loans, you are basically paying for your own money. While this may not sound like a great idea since you already have that money, it’s an option that helps you build credit by showing that you are able to make your required payments on time, every time. This information will be reflected on your credit report, which is why it’s important to take the due dates and required payment amounts seriously.
When it comes to building your credit, your payment history is the most important factor that is used to determine your score. Both secured credit cards and credit builder loans are designed to give you manageable payments for you to make, proving your ability to make on-time payments and therefore raising your credit score.
When used correctly, secured credit cards and credit builder loans can help you raise your low or non-existent credit score so that you can qualify for other lines of credit in the future. However, remember that these options can also hurt your score if you don’t make your payments on time and in full.
What to Be Aware of With Secured Credit Cards
Since your secured credit card still qualifies as a credit card, it’s important to remember that the balance you are carrying will affect the credit utilization aspect of your credit score as well. Taking extra care not to max out the credit card will help ensure your credit score continues to trend upward. Most financial advisors recommend keeping the credit utilization low, at no more than 30% of your total credit limit.
Since secured credit cards and credit builder loans are designed to help you raise your credit score to become eligible for other lines of credit, both are viable options. The decision should be based on what type of use you’re looking for in the credit funds.
If you are simply looking to build credit, the credit builder loan would be the best option for you. If you need the flexibility that revolving credit can offer, then you may prefer the secured credit card. However, if you have a history of maxing out credit cards, then you may want to choose the credit builder loan to help prevent you from overspending.
4 Things to Pay Attention To
Regardless of which option you pick, they both have some elements to them that you need to pay super close attention to. Here are four things to keep an eye on.
1. Late or Missed Payments
While making your payments on time accounts for 35% of your overall FICO credit score, that means that missing your payments is the easiest way to lower your credit score. Be diligent about keeping track of the payment dates and amounts for either your secured credit card or credit builder loan.
If you tend to forget due dates for bills, consider enrolling in autopay. Most financial institutions offer autopay as an option for your monthly payments. This will help you make sure the payment is made when it needs to be, every month.
Most credit agencies report late payments after 30 days of them being late. While this does give you something of a grace period when it comes to making your payment on time, there are other consequences as well. Most banks will charge you a late fee if you miss your payment, regardless of when they report that missed payment to the credit reporting agencies. Paying on time builds your credit, but it also helps you avoid fees!
2. Interest Rates
Secured credit cards and credit builder loans have different ways of accumulating interest, and it’s important to know how each one works so you can be informed and prepared.
With installment loans, like a credit builder loan, the interest that you have to pay is factored into your monthly payment. The interest rate is determined at the time you take the loan out and can either be fixed (not allowed to change) or variable (rate can change during the life of the loan).
With revolving credit, such as credit cards, you are able to avoid paying interest completely. If you pay off your full balance every month, you won’t get hit with an interest charge. However, it’s still important to know what the interest rate on your credit card is and look for lower rates when possible in the case that you do carry a balance over from month to month.
3. Monthly Payments
With credit builder loans, you have a set payment amount each month. Because of this, there isn’t a “minimum payment” option. You are required to pay the full payment amount every month, and it is split between the principal and the interest of the loan.
With a secured credit card, your payment amounts will likely vary from month to month. You will always have a minimum payment each month, which is usually a smaller amount (typically a percentage of the balance on the card). The minimum payment is what you have to pay in order to avoid late fees or penalties on your credit report.
However, if you leave the rest of the balance unpaid, it will start accruing interest, which will make the amount you have to pay much higher over time. So, you’ll receive the on-time payment credit on your credit report, but you may still pay more than you originally planned by holding a balance.
4. Credit Utilization
With a secured credit card, it’s important to keep an eye on your credit utilization. If you are carrying a higher balance on your card, it can negatively impact your credit score. Again, most credit experts recommend using no more than 30% of your available credit to optimize your score.
Your credit utilization ratio is the amount of credit used divided by the total amount of your credit limit. Since most secured credit cards have lower credit limits, it’s extra important to keep an eye on your utilization.
The credit utilization for credit builder loans is also factored into your credit score, but it doesn’t affect your score nearly as much as credit card utilization does. With both, your utilization is reported to credit agencies on a monthly basis. When making payments on time, your credit builder loan utilization will go down month after month, while your secured credit card balance may fluctuate.
Secured credit cards and credit builder loans are both great options for anyone who is looking to either develop credit or improve a poor credit score. Secured credit cards give you the flexibility that revolving credit has to offer. In contrast, credit building loans are a good option for anyone simply looking to create on-time payment history.
When choosing which option is right for you, you need to determine how disciplined you can be with revolving credit. Both credit options can improve your credit score, but they can also lower your score if you don’t utilize them correctly.
With both, make sure you’re only borrowing what you can pay off and make your full payments on time every single month. Doing this will help you improve your credit and qualify you for a wider range of credit lines in the future!