Prepaid credit cards, more accurately known as a secured credit cards, have a credit limit based on a security deposit the account holder must make upfront. In all other respects, this type of account functions like a standard unsecured credit card. Credit accounts of all types require that payments be made on time and the account be used responsibly, but a security deposit lowers the risk to the bank, making prepaid credit cards easier for many people to get.
Credit vs. Debit
Prepaid credit cards are different than prepaid debit cards. A debit card deducts funds from the amount of money deposited into the account associated with it, whereas a credit card makes purchases on credit, which must be repaid using funds from another account. In the case of a secured card, the funds used to pay the bill cannot come from of the security deposit in most situations.
Many people look into this financial solution because of poor credit. A prepaid credit card will improve a person's credit only if payments are made in a timely manner. If timely payments aren't possible, a prepaid debit card may be a more appropriate solution, since the money will be automatically deducted.
Getting an Account
To open a secured line of credit, an applicant must first find a company offering this service. Prepaid credit cards may require an application fee as well as an annual fee. The amount that the issuing company charges can vary widely, so applicants should thoroughly research any card they are considering, along with the company and the credit contract. The person will have to apply for the card as with any other credit application.
Once approved, the person will need to set up the account and pay the security deposit. The amount of the deposit is typically the same as the credit limit; it may be possible to increase this limit if more money is later added to the deposit. Once the money is deposited, the account holder is issued a physical credit card that can be used just like any other.
Usually, the person who opened the account will be sent a bill each month for the amount of money he or she has charged on the card. Each company has its own policies, however, and all bills should have their due dates clearly stated. If a payment is missed, the account holder will likely be charged a penalty, and any amount that is not paid off at the end of the billing cycle will have an interest charge — some percentage of that original amount — added to it.
Advantages and Disadvantages
People with poor credit are often eligible for a prepaid credit card even when they may not get approved for a standard one. As such, it is often used as a way of building good credit. By making regular small charges and paying them off each month, borrower can show that he or she is financially responsible. In many cases, after a year or so of making regular payments, a secured account may be converted to an unsecured one.
Many prepaid credit cards are subject to very high fees and interest, however. This means that, if the charges aren't paid off each billing cycle, the amount the person owes may grow quickly. This can make a secured account riskier than other types, because the security deposit may be forfeited if the borrower cannot pay. Additionally, the security deposit may not earn much interest, and it cannot be accessed easily by the account owner.
In some cases, a prepaid credit card may be "flagged" as such on the borrower's credit report. This tells other potential creditors that the account is secured, and can make it more difficult for the person to improve his or her credit. A person who is already struggling with financial problems may find that these disadvantages only make the issues worse, defeating the potential benefits of the card to improve the person's credit rating.