The 411 On Secured Credit Cards

If you’re trying to establish or rebuild your credit, you’ve probably heard that a secured card is a good way to get started. With a secured card, you place a security deposit with the issuer and, in turn, get a major credit card — often quite easily.

But is your security deposit safe? A reader posted the following question on the Credit.com blog:

I have a secured credit card and have closed the account. The amount deposited for security more than covers the balance on the card, but the credit card company wants me to pay off the card (and pay interest on it until it’s paid off even though the account is closed and cannot be used) rather than using the amount already deposited with them. Is this legit? The bank (that originally issued) the card failed, and now the card is with a different bank that is almost impossible to get in touch with. I’m afraid that if I pay off the balance, I’ll never get my security deposit back. Any ideas on this? — William

William’s experience raises some important questions about how secured cards work, and is a reminder of why it’s important to choose a secured card carefully.

The security deposit you use to open a secured card is a lot like the security deposit you give to a landlord when you rent an apartment. If you pay your rent and take care of the apartment, you get your security deposit back when you move out. If you don’t, you may end up forfeiting part or all of your deposit. Similarly, with a secured card if you manage your account properly and pay all your bills, you get your deposit back after you close your account.

At least that’s the way it is supposed to work. But just like a bad landlord can hold the deposit and force you to fight to get it back, a secured card issuer that isn’t reputable can make it difficult to get your deposit back.

For safety’s sake, choose an issuer that will hold your funds in a federally-insured back account. Typically, that will be an FDIC-insured bank, though some credit unions also offer secured cards to their members and should be insured through NCUA. You can also research the safety and soundness of the bank that will hold the funds, or use it to check out a bank that currently has your deposit.

Watch out for red flags that could indicate you aren’t dealing with a reputable company. “Legitimate secured card providers will offer a variety of ways of funding the security deposit — including online transfer from a checking account or by using a debit card,” says John Yardley, spokesman for First Progress Card, a leading national provider of secured MasterCard credit cards. “They should never ask you to send cash, or to make a check out to anyone other than the financial institution.” He warns that “since the applicant is putting up a deposit, secured and prepaid card offers can sometimes be used as a scam — especially online.”

With many of these programs, your credit line will be equal to your deposit. To raise your credit limit, you’ll usually have to add funds to your deposit, though some programs will gradually increase your credit limit once you’ve established a positive payment history. And a few offer a “graduation” feature where you can get an unsecured card after a certain period of on-time payments, if you qualify. Or you may simply decide to move on to another card once your credit has improved.

When you are ready to close your account, ask the issuer for instructions if you aren’t sure how to do that. Just as some tenants don’t pay their last month’s rent because they figure their security deposit should cover it, some secured card holders may assume they can simply stop paying the bills and let their deposit cover their final bill. But that can be a costly assumption.

Many consumers choose secured cards at least in part because they are trying to establish a positive credit rating. And hopefully they’ve chosen a card that will report payments to all three credit reporting agencies each month. While that can help improve their credit scores, it can also backfire if the cardholder decides to stop paying the bills. Some issuers may report those missed payments to the credit reporting agencies, causing the cardholder’s credit scores to drop.

That’s not always the case, though. “At First Progress we report card accounts to the bureaus as ‘closed — paid in full’ so long as the security deposit covers the charges on the card account, even if the account was closed because payments were not made,” says Yardley. He adds, “It’s possible that other card programs may leave a derogatory record in the cardholder’s credit bureau file in this type of situation.”

How long does it take to get a secured card deposit back when you close the account? It shouldn’t take long if you are dealing with a reputable issuer. While there may be a short waiting period to make sure all charges have posted to the account, you shouldn’t have to wait forever to get your money back. “If the account is closed without a balance owed, the full security deposit should be provided back to the cardholder within ten days,” Yardley suggests.

Since William’s card issuer has already indicated that he needs to pay the balance before he can get his deposit back, he may be at risk of damaging his credit if he decides to stop paying. Plus the issuer may charge him interest and late fees. He may be better off paying the balance and then requesting a refund.

To be on the safe side, William can research the contact information for the banking regulator for the issuer that holds his deposit in advance. Hopefully he won’t need to contact them, but he’ll know where to turn if he does have trouble getting his money back and needs to file a complaint.

[Credit Cards: Research and compare secured credit cards at Credit.com.]

Image: natloans, via Flickr