Secured credit cards are often promoted as the best tool to begin building credit. In fact, they are so normalized that few consumers take the time to recognize their disadvantages, because the assumption is that there is no alternative.

Today, there are a number of alternatives, so it's worth mentioning the downsides.

How They Work

To understand the downsides of secured credit cards, we first need a basic idea of how they work. Secured cards are, as the name suggests, secured by collateral. The consumer applies for the card, and the card issuer decides whether to approve the application.

In the case of a positive decision, the card issuer will propose a credit limit. On unsecured credit cards, the credit limit is the maximum amount of revolving credit the borrower can draw down at any time.

The same applies to secured cards, but there's a catch: the cardholder must deposit the amount of the credit limit upfront. In other words, the cardholder borrows from themselves.

To add insult to injury, the card issuer retains full control over the deposit. There is no predefined date at which the deposit is refunded, or "graduated," to an unsecured card, and it is possible the card issuer never releases the funds.

Disadvantages

There are unique disadvantages associated with every specific card offer, but the general downsides are locked deposits, unspecified deposit refund dates, high interest rates, low credit limits, and an excessively high number of offers.

1. Locked Deposit

The consumer must place a deposit on account for the amount of the proposed credit limit. For example, if the card issuer determines the consumer merits a $500 credit limit, then the consumer must place $500 in a locked account.

Each transaction on the card charges against the credit limit, but unlike normal cards, the lender does not have to "lend" this amount because the cardholder's deposit covers the transactions. In the event of default, the lender can simply withhold the deposit to cover its losses.

Given that the card issuer assumes zero risk, logic would suggest interest is not required, but as we'll see in section 3 below, interest still applies.

2. Refund Controlled by Card Issuer

The card issue retains the right to refund at its discretion. The obligation to deposit the amount of the credit limit on account indefinitely is a normalized but outdated structure. It places unreasonably unbalanced control in the hands of the card issuer, who can effectively retain it forever.

This power is based on the idea that the lender must be able to reevaluate the cardholder for unsecured status and always has discretion to deny based on the credit profile.

The issue with this structure is that the lender may be influenced by factors other than the borrower's creditworthiness.

For example, it may be influenced by the need for additional cash reserves in the secured card business segment to support lending activities in the unsecured business segment.

In fact, some card issuers are notorious for never reimbursing collateral on deposit. Cardholders who improve their credit with healthy use of the card end up having to submit entirely new card applications to obtain an unsecured revolving line.

And the deposit sits on deposit as "free money" to the card issuer, indefinitely.

3. High Interest Rates and Additional Fees

The interest rates on secured credit cards usually hover approximately 3% higher than rates on unsecured credit cards. In addition, roughly 65% of secured cards charge an annual fee. These are surprising dynamics given that secured credit cards are entirely covered by the deposit.

The question consumers can ask is, why? If the maximum card balance is entirely covered by the deposit, why should secured interest rates exceed those of normal cards?

There is an argument for lower secured interest in the event the cardholder uses the full amount of the credit limit. In this case, the card issuer can cover its losses with the deposit, and interest compensates it for the time that money is unavailable.

However, higher interest than unsecured cards has zero justification. It's not only a material disadvantage for the cardholder but also a glaring inconsistency in card issuer terms and conditions, industry-wide.

4. Low Credit Limit

Secured credit card limits are not only covered in full by the deposit, they're also low. Many cards offer credit limits in the $200 - $500 range. In terms of collateral, it might seem that this is a good thing because it means paying a smaller deposit upfront.

However, there is nuance from a credit-building perspective due to something called credit utilization. The consensus is that cardholders should not use more than 30% of their total credit limit, and preferably less than 10%. With a credit limit of $200, the ideal would be to charge $20 or less per month on the card.

Our experience working with consumers shows managing small values like this is easier said than done. Consumers very easily default to a standard payment method, and the result in practice is that many people overspend because they forget to control purchases, or forget to use the card altogether.

On the other hand, it also means that consumers must pay closer attention to their expenses each month to avoid surpassing a high credit usage.

5. High Number of Offers

The least obvious disadvantage of secured credit cards is the sheer number of offers on the market. The terms of secured cards are so favorable to cardholders that nearly every bank and credit union institution offers one.

In other words, a consumer is often familiar with the concept of secured cards. As a result, they assume they are effective. This has created an atmosphere of knee-jerk confidence in the power of secured cards. As we'll see next, there are alternatives.

Ubiquity also leads to cognitive laziness, and many consumers assume all cards are equal, accepting without regard to nuances across offers. As with many financial products, understanding the details is less important than testimony from recognizable brands. Consumers often choose weaker offers as a result.

Moreover, the number of offers makes it challenging to find an optimal secured card offer. It's like finding a needle in a haystack. Many cardholders obtain their card out of convenience and proximity to the nearest offer, which can result in complicated relationships with subpar card issuers thereafter, often without obtaining a return of the security deposit.

Finding a competitive offer and not spending more than necessary on deposit, fees, and interest is almost impossible today. In a digital age where the highest bidder wins its place as "the best" in search engine results pages, this is why we do not take commissions on product recommendations.

Alternatives

The primary alternative to secured credit cards is a growing category called credit builder cards. Unlike secured cards, they do not require security deposits.

The reason any person wants a secured card is that they are denied unsecured (i.e., "normal") credit cards due to a poor credit profile. Secured cards were the original solution to help lenders accept poor profiles using a security deposit.

Now, the deposit is no longer a necessity. Credit builder cards use a number of alternative techniques such as rolling prepaid accounts and flash credit transactions to accept consumers with subpar credit.

Popular examples include Zolve Aspire and Petal.

If you're interested in credit builder cards, consider taking our free credit profile quiz on the homepage.