By Larry Santucci, Senior Industry Specialist, Federal Reserve Bank of Philadelphia
In the years following the Great Recession, US banks, regulatory agencies and consumer-advocacy groups began focusing on ways to help consumers improve their financial wellbeing. Recent studies suggest that, by requiring upfront collateral and reporting payment activity to credit bureaus, secured credit cards can play an important role in that process.
A 2016 Federal Reserve Bank of Philadelphia discussion paper, “The Secured Credit Card Market”, sheds light on several key aspects of the secured credit-card market and its users, who tend to either have a credit history marred by bankruptcy or foreclosure or who lack a credit history entirely. (The data used in “The Secured Credit Card Market” paper comes from an anonymized administrative dataset that was made available for research purposes. Unless otherwise stated, statistics provided in this article are derived from credit-card accounts open as of December 2015.) The paper explores the history of secured credit cards, surveys current pricing and features, and examines the financial outcomes of consumers who open a secured card account. In particular, the author reports that more than 82 percent of customers who open a secured card account are able to keep it open for at least 24 months, and that doing so is associated with a 24-point improvement in their median credit score. At the same time, an improvement in credit score is by no means guaranteed, and, in some cases, the consumer’s collateral is liquidated to offset a severely delinquent balance.
A brief history of secured cards
The first secured cards were originated by California-based savings and loans during the late 1970s. Little has been written about how or why they first came into existence, although they likely began as informal arrangements between branch managers and well-known customers, inspired by other kinds of collateralized loans. In a typical arrangement, the branch manager would agree to provide the customer with a (standard) credit card on the condition that he or she maintains some minimum balance in a deposit account.
Lacking the technology or risk-management experience to underwrite secured cards safely, most banks were hesitant to develop broad-based secured card programs, and growth remained slow for decades. In recent years, however, the secured card market has experienced increased growth, albeit remaining a small segment of the consumer credit-card market. Since June 2012, the number of open secured card accounts held by large bank holding companies has increased at an annualized rate of 22 percent to 3.3 million, as of December 2015. Despite the strong growth, secured cards still represent less than 1 percent of the entire credit-card market.
These days, banks require that a consumer opening a secured card account place a percentage of the credit limit in a deposit account as collateral. The collateral ratio often begins at 50 to 100 percent and will decrease over time as the consumer demonstrates the ability to make timely payments. Some banks have an explicit graduation strategy whereby a secured card customer is reviewed for graduation to an unsecured card after a period of months, at which time the full collateral is released. On the other hand, if a secured card account enters default, the bank will offset any unpaid balance by liquidating the collateral account.
The distribution of credit-risk scores for secured card accountholders (with a credit score) is skewed toward high risk. About 67 percent of secured card customers have a FICO® score below 620 compared with 1.6 percent for consumers with unsecured cards opened during the same time period. Secured card customers also tend to have much lower incomes at account opening. The median annual income for secured card accountholders is $35,000 compared with $50,000 for unsecured accountholders, a difference of 43 percent. Part of this difference may be attributed to consumer demographics: Secured card customers were 8.5 years younger on average than unsecured card customers (author’s calculation using anonymized credit-bureau data).
Today’s secured card market
Although secured cards are available through a variety of financial institutions, the market is dominated by a handful of large banks, some of which also dominate the unsecured credit-card market. Secured cards issued by these institutions tend to be general-purpose credit cards with few extra features and promotional offers. Only about 12 percent of open secured cards have a rewards program. Although collateralized, secured cards tend to have less favorable pricing terms than unsecured cards. Most secured cards charge an annual fee and often have higher purchase annual percentage rates (APRs) than their unsecured counterparts. As noted in the previous section, there are many differences between secured and unsecured customers, including income and credit-risk characteristics, all of which may contribute to pricing differences between the two products.
More than 80 percent of secured card customers pay an annual fee, compared with 10 percent of open unsecured cards. Annual fees for secured cards range from $18 to $125, although most charge $29. In contrast, annual fees for unsecured cards can be as low as $18 or as high as $950, since banks tend to charge substantial annual fees for their high-end (or “prestige”) unsecured cards.
Secured cards also tend to have higher purchase annual percentage rates (APRs) than unsecured cards. The distribution of purchase APRs on secured cards is heavily concentrated in the 15-to-25-percent range, whereas APRs for unsecured cards are much more evenly distributed between 10 and 29.99 percent. Very few secured cards have an APR of 15 percent or less. In fact, while 33.7 percent of unsecured cards have an APR of 15 percent or less, just 3.8 percent of open secured cards do.
Credit limits on secured card accounts tend to be very low. More than 76 percent of open accounts have an initial credit limit of $200, $300 or $500. This is likely due to several factors, including banks’ reluctance to extend too much credit—even on a secured basis—to risky (or unproven) consumers. More important, consumers themselves may be reluctant to relinquish access to a more substantial sum of money or may be unable to accumulate a larger deposit.
Do credit scores improve?
Routinely using and making timely payments on a secured card account are just two of the many factors that influence changes in credit scores over time. Scoring algorithms typically consider a wide variety of payment, usage, collections and public-record data when calculating a consumer’s risk score. While the Federal Reserve report cannot determine whether responsible use of a secured card account in and of itself leads to higher credit scores, it does find that keeping a secured card account open is correlated with improved creditworthiness. As shown in the chart, maintaining an open secured card account for two years was associated with a 24-point increase in median credit score, while being charged off by the lender was associated with a 60-point decrease in median credit score. On the other hand, the median score for consumers whose accounts closed before reaching two-year maturity is at least 42 points lower than at the time of the account opening.
Secured credit cards provide consumers with an opportunity to improve their financial wellbeing by simultaneously accumulating savings and improving their credit score. By doing so, consumers are better positioned to handle unexpected earnings shortfalls, and, in the longer term, be approved for other lower-cost credit products. Most consumers who open a secured card account engage in behavior that improves their credit scores, although about 18 percent of them experience more detrimental credit events than beneficial ones, leading to a substantially lower credit score. For those consumers, opening a secured card account should be part of a more comprehensive financial plan that assists them with budgeting, debt management and debt consolidation.
The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
Larry Santucci, “The Secured Credit Card Market”, Federal Reserve Bank of Philadelphia Payment Cards Center Discussion Paper, November 2016, www.philadelphiafed.org/-/media/consumer-credit-and-payments/payment-cards-center/publications/discussion-papers/2016/dp16-03_the-secured-credit-card.pdf?la=en