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I was trying to explain to people in Europe the obsession with the credit score in North America and the topic of secured cards came up. I know the concept, but unless the goal is to abuse people in difficulty, there is a part I do not understand.

My assumptions are:

  • You are borrowing your own money, so the risk doesn't exist for the financial institution

  • Managing a secure credit card is most likely the same cost as a regular card, so the bank has a known cost for the account.

My questions are:

  • Since you are the lender, why aren't you collecting the interest, minus bank costs, for the service?

  • Why do they have such high APR?

  • Is there any other justification than 'because they can' to explain the terms, considering they take no risk?

I realize that some people may be in desperate need to build credit and will go through anything, but from my perspective it looks like a horrible product designed to feed in a questionable credit rating system :)

Is there any rationale behind these three points?

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    Secured credit cards have collateral in the same way that mortgages are backed by houses. As for why the high APR? That's irrelevant if you pay your bills on time. – RonJohn Nov 25 '19 at 20:24
  • when trying to understand the logic, the APR is relevant :) – Thomas Nov 25 '19 at 20:31
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    @Thomas What he means is that if you pay the statement balance on time every month, then you don't get charged interest and the APR doesn't matter. – D Stanley Nov 25 '19 at 20:33
  • There is no one APR on every secured card. – RonJohn Nov 25 '19 at 20:35
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    Note: Some secured cards give you a credit limit higher than your security deposit (i.e. a $500 deposit might get you a $1000 limit). In this case, the risk to the bank is reduced, but not to zero. – ceejayoz Nov 26 '19 at 14:14
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D Stanley's answer addresses the mechanics of secured cards well and does a good job of directly answering your question. I wanted to post a separate answer to provide a bit of a frame-challenge to your assertion that secured cards are a "horrible" product, because I don't think that's reflected in the facts and the data around how consumers and lenders use this type of product when it's implemented as intended. (While some lenders may use secured cards to take advantage of consumers, that happens with all types of products and I don't think that counts as a fair representation).

You are correct that secured cards are typically aimed at people who have poor credit and cannot use other types of credit. Lending in the US is typically based on a number of factors:

  • Understanding a consumer's cash flow. People need to prove that they have income to pay back their creditors. This is typically done via either consumer-volunteered data (i.e. a box on an application that says "Income:") or via more direct income verification (i.e. providing pay stubs, tax returns, etc). Typically, income is balanced against outstanding debt, which again is often consumer-supplied and/or verified externally (via a credit report).
  • Understanding a how a consumer behaves, in terms of lending risk (will they pay their bills on time?) This is done via credit scoring, which you've referenced in your question. The credit scoring system in the US is based on using data to predict the likelihood that a consumer will default on a new loan in the near future. The models are trained to consider "unknown" similarly to "bad" in the sense that a consumer with no history is treated similar to a consumer with bad history.

Your question really hinges on the second point - understanding the risk that a consumer presents to the lender. Lenders use credit score in two ways - first, to determine if they will approve a loan for a consumer, but secondly to help them price a loan. Loans are priced higher for riskier consumers.

The model generally works in the sense that it helps lenders make decisions about consumers. However, the model also presents a problem - if a consumer has no credit history, or a poor credit history, they may have a score that is so low that no lender will even lend to them. Lenders can't just price a traditional credit card high enough to cover the risk, because interest rates are capped by law. Hence, people with very poor credit scores essentially have no way to get back "in to the system" where they're scored high enough to obtain typical consumer loans. For someone trying to get to the point of buying a home or making another major credit commitment, this can be very limiting.

That's the problem a secured card is designed to solve - it provides a loan type that's backed by collateral (the deposit) and hence can be priced appropriately, even for consumers with very bad credit scores. In many cases, it may be the only credit someone can obtain.

On the surface, a secured card may make no sense - why put down a deposit just to get a credit card, when you could just manage your own money? The secured card isn't intended only to replace a traditional card, it's intended mostly to provide a stepping stone to allow a consumer to get to good standing. In that sense, while it may be easy to criticize a product aimed at people in poor standing, another viewpoint is that you're throwing them a lifeline and allowing them to build a better financial picture for themselves.

And, when looking at trends in consumer data, that is how things basically play out. From a lender's perspective, the deposit has a direct impact on the risk of the loan because it is available as collateral for the lender to take if the loan is not paid back. But, that's not the full picture - the deposit also typically creates a change in behavior among consumers. People who put a deposit down feel more invested, because they have something at stake. If you've already got poor credit and you walk away from a loan, you may feel like you're not losing anything. But if you've got poor credit and you walk away from a loan and a cash deposit, that hurts a bit more! People who take out secured card loans are more likely to pay them back than their peers who take out traditional credit cards. That's good, because the pricing and approval process shifts even further than it would when just considering the collateral offset to risk.

It's also good because the consumer is learning good habits, by training themselves to respect the loan and pay it back on time. Consumers who intend to use a secured loan to rebuild their credit typically end up in better standing in the long term than those who don't.

So, while it may be easy to write it off as a "horrible" product, when implemented correctly, it's essentially the opposite that is true. When a consumer intends to rebuild their credit, a secured card can often be the best tool they have available to them.

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    Thanks! I think this explained very clearly why the product exists. On the surface, I was wondering why does this even exist in the first place. Now I do understand the reasoning behind it. – Thomas Nov 27 '19 at 20:10
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my assumptions are: - you are borrowing your own money

You are not borrowing your own money. The bank is still lending you the money. But if you default, meaning you don't pay back what you're borrowed, then the bank can take what the card is secured against to recover their money.

It's very much like a car loan. If you don't make the payments, then the bank can seize (repossess) your car and sell it to get some or all of their money back.

why do they have such high APR?

Because the fact that you need a secured card and not an unsecured card probably means that there is a significant risk that you won't pay back what you've borrowed. Therefore the bank changes a higher interest rate to compensate for the additional risk.

from my perspective it looks like a horrible product designed to feed in a questionable credit rating system

I'm not sure what you mean by the mast part, but it targets those that can't get traditional unsecured lines of credit. Just like predatory car loans, if that's the only option you have to borrow money then it's going to cost you more interest. Your choice as a consumer is to either use them or nothing.

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    Regarding the last paragraph... the big difference is that there is a mandatory interest payment on auto loans, whereas there's no interest on CC if you pay it on time. (And secured cards are also issued to young people with low scores because of minimal history.) – RonJohn Nov 25 '19 at 20:39
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    @RonJohn True the mechanics are different, but my point was that it is targeted to those that don't have better options to borrow money. – D Stanley Nov 25 '19 at 20:41
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    I'm a little lost on how it counts as a "horrible" product. Most people who take out secured credit card loans have literally no other option to borrow. It becomes a chicken and egg problem, how do you get credit if you need good credit to get credit? Without secured credit cards, people who had no credit history, or a poor credit history, would essentially have no way to rebuild a good standing. I'd argue that it's one of the best products since its inherently designed to help people who actually need help, versus just earning interest off people who don't need help. – dwizum Nov 26 '19 at 16:19
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    @dwizum Fair enough - I've taken out that judgment. But I would argue that you don't need a product like this to build credit. Unless you have a bad credit history (versus no credit history) you can earn good credit just by getting an intro (non-secured) card and paying it off every month (or at least not paying it late). Even with a bad history you can probably get a card with a high APR and just pay it off every month. – D Stanley Nov 26 '19 at 16:29
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    @dwizum No worries, but your experience sounds different form mine. Go to a college campus on game day or around the start of school and it's littered with credit card companies giving out t-shirts. And it's not to get secured cards. It's to get 18-22% unsecured cards that they hope you'll pay interest on. – D Stanley Nov 26 '19 at 16:47

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