The genius of secured credit cards

For someone who has a credit score below about 630, the system seems rigged against them.  Almost all credit card issuers will deny someone below this range and the few who will accept the applicant will charge exorbitant fees, like a $99 annual fee, and very high interest rates.

The basic problem for such a person is that they are undercapitalized - in plain English, they don't have enough savings.  Step One is to build an emergency fund of at least $1000.  When you have the money, take $500 and put it as a deposit on a secured card.  You don't want to put all of it as a deposit on a secured card because you want to make sure you can pay back what you charge.  So the charges are secured twice, first by the deposit, and second by savings that can be used to pay the charges.

How much capital do you need?  It depends on the person, but I believe at least $4,000.  Get 3 secured credit cards for $1,000 each and keep $1,000 as savings to make sure you can pay the charges.  The reason why you need multiple cards is because at some point you will close the card and get the deposit back, and you will want to keep at least one card open.  How do you raise $4,000?  It isn't easy but its called spending less than you earn.  It may take a year or longer to raise it.

Don't charge more than 30% on any card.  So if your credit limit is $1,000, don't charge more than $300.  It's ok to use more than that temporarily as long as you very quickly (within a couple of weeks) bring it back to 30%.  And of course, pay off the balance monthly so you don't get interest.

So once someone follows this plan, they will have a $3,000 credit limit and be in an excellent position to get an unsecured card at regular rates within a year.

Why don't people with better credit scores need capital?  Their credit score in a sense is their "capital".  A credit score is worth money, it is a replacement for capital that is otherwise needed.

A further twist is that banks hate issuing secured credit cards.  The solution is to go to a local credit union and see if they have the product.  But why do banks hate it?  First, they are dealing with a high-risk individual who may not pay back the credit card even if it has a deposit.  And if they do seize the deposit it will generate bad will on the part of the customer.  And the bank doesn't profit from this, they are just getting back their money. So why take the risk?  A more subtle reason is that banks really don't want your money.  From their standpoint it is a debt, a liability, and they don't want more debts they want more assets.  A credit card balance is an asset to the bank.  A bank would rather deal with a person with a higher credit score who is more profitable.

Why do secured credit cards charge an annual fee?  It is basically a negative interest rate.  An annual fee of $35 on a $300 card is an interest rate of -11.7%.  They need the fee for it to make sense to them because they have costs in issuing the card, sending out bills, maintaining a website, answering the phone, and maintain the money in an escrow account.  Most credit unions issue secured credit cards without an annual fee, which of course is preferable.

So in conclusion, the genius of a secured credit card is that 1) it forces you to save money; 2) it teaches you good spending habits; and 3) it helps rebuild credit; 4) at a low cost.  And at the end of the year or two, however long it takes, you get your deposit back - which you can then invest in the stock market, but that's a different topic.

See also:  The Genius of Layaway