Why Should I Sign Up for a Secured Credit Card?

They can be a good way to get your credit score out of the basement, but there are some caveats. Image source: Getty Images.

Credit cards are useful tools for establishing yourself as a responsible payer in the eyes of financial institutions. Use them properly, and you'll build a history that will make it easier for you to get bigger loans and secure better interest rates. But if your credit report is riddled with late payments and maxed-out credit cards, you'll have trouble finding financial institutions willing to lend to you.

That's where secured credit cards come in. They're designed to help individuals with poor credit -- generally considered to be a credit score that's 630 or below, though some set the threshold as high as 650 -- build or rebuild their creditworthiness over time. Secured cards are similar to traditional credit cards, but there are a few key differences.

How do secured credit cards work?

Secured credit cards require a security deposit when you open the card. Usually, this deposit starts around $200 and is equal to your credit limit, though some cards don't tie the two together. The deposit is simply a guarantee for the creditor, giving it a way to recoup its losses if you fail to keep up with your monthly payments. But as long as you pay back what you owe, your security deposit will be refunded to you when you close the account.

Creditors report your monthly payments (or lack thereof) to the three major credit bureaus. Making on-time payments will raise your credit score over time, which can open the door to better, unsecured credit cards. It usually takes most people about a year of responsible paying before they reach this point, but it may be slightly more or less for you, depending on where your credit score was when you opened your account and how responsible you are with your secured card.

Lending to individuals with poor credit can be risky, so it's not uncommon for creditors to charge annual fees, account opening fees, and monthly maintenance fees on secured credit cards -- charges that can add up to more than $100 per year. This amount comes off of your monthly credit limit. Secured credit cards are also known for their high interest rates -- it's not uncommon for their APRs to exceed 25%, so it can get expensive if you carry a balance. Before you sign up for a secured credit card, read the cardholder agreement thoroughly so you know what kinds of fees to expect.

Most secured credit cards are pretty basic, but a few offer rewards just like unsecured cards. If the card you're considering does offer rewards, try to estimate how much you're likely to earn from them and compare that amount to the fees you'll pay to determine whether the card is a good value.

How to use a secured credit card properly

Don't expect to use your secured credit card for all of your purchases each month. For one, your credit limit may not allow it. For another, you don't want to risk charging more than you can pay off in a month, or else you'll have to pay interest.

You're much better off using your secured credit card to make one or two smaller purchases each month. Try to avoid getting too close to your credit limit, because the credit agencies look askance at people with a high credit utilization ratio -- the amount of credit you're using versus the total amount available to you. A high ratio will lower your credit score.

Ideally, you want a credit utilization ratio of 30% or less, but this may not be possible if your credit limit is only $200. That would only leave you with $60 to spend, and fees might cut into that even further. In that case, just do your best to keep that ratio as low as you can while still making one or two small purchases each month that you can easily pay off.

Pay your balance in full and on time each month. This signifies to creditors that you're living comfortably within your means. It also keeps you from being charged any interest on your purchases. Once people begin the cycle of carrying a credit card balance, the high interest often keeps them in debt for months or even years.

Monitor your credit score every month to see how it's improving over time. Once your credit score cracks 630, you may want to think about applying for an unsecured credit card. This will often net you more rewards, and many of these cards do not charge any monthly maintenance fees. Some card issuers may automatically consider you for an upgrade to an unsecured credit card after a few months of on-time payments.

When used responsibly, a secured credit card can be an excellent tool for building or rebuilding your credit score. But it's important to understand exactly what the terms of your agreement are before you sign up, and to use such cards sparingly until your credit score comes up.

RELATED: Check out Motley Fool Money's Wells Fargo Business Secured Card review.