How Credit Works: Secured vs. Unsecured Debt
In the previous posts in this series, we’ve looked at how your FICO score works and how to build your credit if you’re starting from scratch. One of the biggest steps to take when building your credit rating is to open a credit card and pay it off regularly (weekly or monthly) to build that credit score and show that you’re a good risk to future lenders.
There are two major types of credit cards to choose from: secured and unsecured. To know which is best for you, it helps to understand exactly what secured debt and unsecured debt are.
Defining Unsecured Debt
An unsecured debt is one that isn’t backed up by any collateral. That means that the lender gives you money that they might not ever get back if you default — that is, you stop making payments. Most credit cards, for example, are unsecured debt. If you rack up a balance and then skip town, the credit card company can’t come after to you take away all the things you bought with the credit card. Likewise, a student loan is unsecured debt because no one can come take your degree away if you default.
Don’t think that unsecured debt is free money, though. This type of credit is much riskier for the lender, since they can’t do much to come after you if you don’t pay. That means that lenders protect themselves by charging higher interest rates on unsecured debt — and they often base those interest rates on your credit score.
Interest rates are a measure of risk and since unsecured debt is very high risk, there is a very high interest rate associated with these types of debt.
Types of unsecured debt include: credit card, student loans and pay day loans. Think of it this way, if the lender cannot physically take something back then it is unsecured and usually has a very high interest rate.
Defining Secured Debt
Secured debt, on the other hand, is directly connected with collateral that the lender can repossess if you fail to pay your bills. An auto loan and a mortgage are common examples of secured debt, since your car and your house are on the line if you default. Since you as a borrower have more skin in the game with secured debt, you can usually get lower interest rates on house and car loans than you can on a credit card.
Secured vs. Unsecured Credit Cards
When you think of credit cards, you’re probably thinking of unsecured cards — those “magic” pieces of plastic that let people buy whatever they want without actually having money in their pockets. They’re very convenient, but they’re also easy to abuse if you buy things you can’t afford and don’t pay off your balance each month.
Unsecured cards aren’t tied to collateral, so credit card companies only offer them to people with good credit scores. If you’ve tried applying for an unsecured, traditional credit card but have been turned down, a secured credit card is a great alternative to help you boost your credit score.
A secured credit card requires you to pay a security deposit up front. For example, you may write the credit card company a check for $500, and they’ll give you a $500 credit limit. They hold onto that check as a safety measure and will use it if you don’t pay your bills. This means that the credit card company can never lose any money if you can’t pay, because you already paid them the security deposit.
A secured credit card is a great way to build credit. My first credit card had a $100 limit after I sent the credit card company a check for $100. Now my credit limit is in excess of $100,000 on my credit card about 10 years later. You can responsibly build credit by first starting with a secured credit card. I cannot hammer home the point enough that I have paid every credit card I have had every week or every month. I have never carried a balance.
After you’ve built your credit score up by paying your secured credit card on time and in full for many months, you can try applying for a standard, unsecured card again. When you close your secured card, you’ll get your original deposit back, too. If you have poor or no credit, this is probably your best shot at building credit for the future. The best part is it does not involve anyone else. We highly recommend not trying to use a family member to co-sign for you to build your credit. Do this on your own to not put any of your family members or loved ones in financial jeopardy.
The Bottom Line
No matter what kind of credit card you use, the number one thing is to use them only for necessities so you can pay off the bills every month — or even every week! You can learn more about building your credit and sticking to a budget by subscribing to our online courses or reading more on our personal finance blog.