At least once a week a reader emails me to ask whether they can improve their credit with a prepaid credit card. Although the answer is a bit more complicated than this, I tell them no. If you are rebuilding your credit, the best type of card to use is a secured credit card. And that usually leads to a follow up question–what is the difference between a prepaid card and a secured credit card?
So rather than answer this question one reader at a time, here’s everything you need to know about these types of cards.
Prepaid Versus Secured Credit Cards
While these two types of credit cards are very similar, there are some significant differences. A prepaid credit card works very much like a bank debit card. Once you deposit money on the prepaid card (via direct deposit, bank transfer, or cash), you can use the card anywhere that accepts debit MasterCard or Visa. It can be used to shop online, over the phone, or at virtually all retailers.
Once you’ve spent the money you initially deposited, you must add more funds to continue using the card. For this reason, these cards are often referred to as reloadable prepaid cards (in contrast to say gift cards).
Important: Because you are spending your own money that you’ve added to the card, prepaid cards generally cannot help you improve your credit score.
Secured cards, on the other hand, work like traditional credit cards. You can use the card just like any other credit card up to your credit limit. Each month you’ll receive a statement with your charges and the amount of your minimum payment. Make your payments on time, and your credit should improve. In contrast, late payments will hurt your credit score.
But there is one hitch.
Secured credit cards require you to make a cash deposit (typically $200 to $5,000) with the card issuer before you can use the card. Furthermore, your credit limit is generally equal to the amount of your deposit. The bank then holds your deposit as security in the event you fail to pay your credit card bill. Because of this security deposit, folks with bad credit can generally qualify for a secured credit card, even if they could not get a traditional card. And that’s why these types of cards are perfect for those looking to rebuild their credit after a bankruptcy or foreclosure.
So which one is right for you?
Here are some tips on picking the right card for you:
- Building Credit: There’s no question that if you want to improve your credit, than a secured card is the better choice. There are some prepaid cards that can help build your credit, but they can’t help improve your FICO score, which is the credit score that most lenders use to evaluate your credit.
- Banking Alternative: If you are looking to use a card in place of a bank account, the prepaid card is the better choice. You can pay bills online with most prepaid cards and even write checks. In fact, with the increase in banking fees, the prepaid card market is growing as people abandon banks.
- Check Cashing Store Alternative: To avoid the expense and risk of using check cashing stores, many turn to prepaid cards. These cards allow you to use direct deposit of a paycheck or government benefits check. You get access to your money faster and without the fees of a check cashing store. Secured cards do not offer this option.
Beware of Fees
Both secured and prepaid cards can come with hefty fees. Just a few years ago it was almost impossible to find one of these cards without fees so large it felt like somebody punched you in the gut. Today, however, there are low fee and even free options.
The best prepaid credit cards do not charge a per transaction fee. These cards also enable you to avoid a monthly fee if you use direct deposit and load a certain amount of money on the card each month (typically $500 or more).
With the secured cards, the key is to avoid those with a monthly fee. You’ll find a few free options and a few good choices that charge a reasonable annual fee (usually less than $30). But there is no sense paying a monthly fee for a credit card.