Some people think that using prepaid cards can help them build or restore their credit.
It's a myth. Unlike traditional credit cards, prepaid cards are not linked to Social Security numbers, nor is your use of them reported to the credit agencies. The Consumer Financial Protection Bureau recently released a study that found credit card usage is the single most important factor in a person's credit report.
It's more accurate to say that using a prepaid won't damage your credit. That's because of the built-in restrictions on spending and the fact that a prepaid card's usage isn't reported to the credit agencies.
A Prepaid Card Is Not a Secured Card
Before this newest version of plastic arrived on the scene, the phrase "prepaid card" often referred to a card backed by a secured line of credit -- a "secured credit card." Secured credit cards were designed to help people with bad or no credit histories build or repair them, and those cards still serve that purpose. A person with poor credit makes a deposit with the bank, which is held in reserve (like a security deposit). The bank then issues a line of credit equal to the amount held and a piece of plastic emblazoned with the bank's name. The bank reports information about the account (available credit limit, payment history) to the credit reporting agencies.
The result: Banks take relatively little risk; customers can prove their creditworthiness, and ultimately become credit cardholders in good standing.
Credit Card Training Wheels
Although prepaid cards won't help build credit, for a person interested in gaining control over his or her spending, they can be an effective tool for helping to develop healthy money management habits. And with several prepaid cards now offering online money management options, tracking your spending with a prepaid card can be easier than tracking cash transactions.
Says Lauren Francis of Chase (JPM), which issues the Liquid prepaid card: "Chase Liquid customers have full control over their spending because they generally can spend only what they deposited."
But prepaid cards are not without significant drawbacks. Their popularity has outpaced the regulations that govern them, and as a result, prepaid remains largely the Wild West of credit cards. Fees vary widely.
If You Want to Build Credit...
Individuals with poor credit wishing to repair it have options beyond applying for a traditional credit card.
A secured credit card or a low-limit credit card with a local store or a gas station are both great first steps. Also, many utility companies and cellphone providers report payment information to credit bureaus, and consistent on-time payment can help build credit. Although they are not required to report your activity to the credit bureaus, you can request that they do.
Everyone, regardless of credit status, should regularly obtain free copies of their credit report through the three credit bureaus (via AnnualCreditReport.com), and monitor the reports for mistakes. While there are several legitimate credit-monitoring services available, beware of accidentally signing up for an ongoing service when requesting a free credit report.
Motley Fool contributor Molly McCluskey (@MollyEMcCluskey) does not own shares in any of the companies mentioned, or in any credit-monitoring services. The Motley Fool owns shares of JPMorgan Chase & Co.
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