Credit Scores and Prepaid Cards–What You Need to Know

Do prepaid debit cards help build your credit? It’s one of the most frequently asked questions here at PrepaidCards 123. The answer is a resounding ‘no,’ which tends to raise a number of additional questions:

  1. Why don’t prepaid cards affect credit scores?
  2. How do you build credit if prepaid cards can’t help and you don’t want or can’t get a credit card?
  3. How do you track your credit score once you do start building or rebuilding it?

Let’s look at each of these issues in turn.

Why prepaid cards don’t affect your credit score

Credit scores measure our ability to handle credit and debt. From credit cards to school loans to mortgages, credit bureaus track our payments, credit limits, and other factors used to calculate credit scores. The Fair Isaacs Corporation devised the most frequently used credit scoring formula. Named after the company, it is commonly referred to as a FICO score.

Fair Isaac’s name is derived from its founders, Bill Fair and Earl Isaac.

Fair Isaac uses several factors to generate a FICO score for a consumer.  These factors, and the weight placed on each, are the following:

  • Payment History on Debts (35%)
  • Amounts Owed (30%)
  • Length of Credit History (15%)
  • Types of Credit in Use (10%)
  • Applications for New Credit (10%)

The key from the above list is that they all involve credit and debt. Prepaid debit cards, in contrast, are not credit products. Money must be loaded onto a prepaid card before it can be used. Because credit is not extended, using a prepaid card cannot help or hurt your credit score.

How to build credit if prepaid cards won’t help

So what can help? Of course traditional credit cards can help you build credit. Many people, however, either don’t want or can’t get a credit card. For those that fall into this category, a good option is a secured credit card.

Secured credit cards are in some respects like combining a prepaid card and a traditional credit card.  Like a credit card, a secured credit card has a credit limit and a minimum payment on any outstanding balance must be made each month. As a result, how you handle a secured credit card will affect your credit score.

Similar to a prepaid card, however, a secured credit card requires the cardholder to send in a security deposit before using the card. The security deposit typically ranges from a few hundred dollars up to several thousand. While the size of the deposit is up to the cardholder (subject to a minimum amount typically of a few hundred dollars), keep in mind that the credit limit will typically equal the amount of the security deposit.

Because these cards are secured with a deposit, those with poor credit or no credit at all can typically qualify.

How to track your credit score

There are several ways to track your credit score. While some require a credit card and come with a monthly fee, there are options available that are totally free. Here are several of our favorites:

Credit Karma: This free service provides a snapshot of your credit history and your current credit score. It also reveals those factors that are hurting your score and those that are helping. Unlike other services, Credit Karma provides credit reports and scores from two different credit agencies:  TransUnion and Equifax.

Credit Sesame: This site works very much like Credit Karma, but with one difference.  The credit report data and scores comes from Experian. For this reason, it’s smart to sign up for both Credit Karma and Credit Sesame. They are both totally free, and between the two, you get your data from all three of the major credit bureaus.

Prepaid Cards Force You to Budget

How do so many people go astray with credit cards? Simple: they spend more than they can repay in a single month.

When you can’t pay your credit card off in the same month, servicers start hitting you with double-digit interest, even as they require only a small minimal payment. This makes it far too easy for the average consumer to fall into a vicious cycle of spending more than they can pay back, and paying increasingly more in interest.

In other words, a broken budget.

Prepaid debit cards only let you charge what you’ve already funded onto the card. There isn’t even a risk of overdraft fees, like there is with a normal debit card; if you empty your account balance, the card will simply decline.

This forces prepaid debit card holders to only spend what they have available. Read: good budgeting habits.

The Foundation for Effective Credit Card Usage

Credit cards directly impact your credit, as credit card companies report monthly to the three primary credit bureaus. That’s only good news if you use your credit card effectively.

If you maintain a balance on your credit card (especially a balance over 30% of your credit line limit), don’t expect your credit card to do your credit score any favors. The same is true if you miss a monthly payment – expect a hit to your credit.

Your goal may be to get a “normal” credit card, and there’s nothing wrong with that. Credit cards come with plenty of benefits, from rewards to flexibility to building a credit history.

But most people are unprepared for the responsibilities that come with them, when they’re issued their first credit card. They end up learning the hard way just how dangerous credit cards can be.

Consider using a prepaid debit card for at least six months (preferably a year) before applying for your first credit card. It will put you into the habit of living within a budget and making regular monthly payments to a card.

Avoiding Bank Fees

It’s harder than ever to find a bank that offers truly free checking, no strings attached. Most banks that do offer “free checking” attach plenty of caveats: minimum monthly balances, regular direct deposits, your firstborn child, etc.

Prepaid debit cards offer an alternative to relying on a checking account. Many modern prepaid cards can accept your direct deposit payments from your employer, to help you avoid paper checks or cash.

Not everyone trusts banks, either. Prepaid cards can be a first step in shifting your finances from cash-based to electronic, to start modernizing without having to put your faith in a bank just yet.

And as mentioned above, there’s no risk of overdrawing your prepaid card. Banks will slap you with a nasty overdraft fee if you cross the $0 line.

Just be sure you double check what fees a prepaid debit card does charge, before opening one. Look for monthly fees, ATM fees, load fees, and any other fees charged, to make an informed comparison to a traditional checking account and debit card.

Holiday Spending & Other Irregular Expenses

One of the most difficult parts of budgeting is accounting for irregular – but inevitable – expenses like gifts, car repairs, healthcare costs, and the like.

This is where so many people run into trouble with their first credit cards. Sure, they can pay off their credit card in October, when their only expenses were meals out and happy hour. Then December hits, and they suddenly find themselves with a credit card bill laden with gift purchases on top of their normal meals out and happy hour charges.

No one wants to hear it, but they screwed up their budget. They should have been setting aside money all along for irregular expenses like gifts. Barring that, they should have given up the meals out and happy hours, to afford to buy holiday gifts.

Budgets are a zero-sum game: if you spend more in one area, you have to spend less in another. And that includes irregular expenses.

You could learn this lesson the hard way, with a hefty credit card balance that you don’t know how to pay back. A balance that will drive down your credit score.

Or you can learn these financial life lessons on a prepaid debit card, where your credit score isn’t on the line. And, for that matter, where long-term debt isn’t on the line, either.

Good Habits, Good Credit, Healthy Finances

Schools don’t teach personal finance or how to build your credit score. Most parents don’t, either.

That leaves most of us to flounder about on our own, learning as we go. We assume it must be easy, since everyone else seems to be doing fine.

Except they’re not: the average household credit card debt in the US is $8,180.

Before you can build good credit, you need to build good habits. A prepaid debit card can help force you to develop those healthy financial habits, with no risk of overdrawing.

When you’re ready, you can open a checking account, start swiping a traditional debit card, and then explore introductory credit cards. There are even tools out there to help you keep your credit card spending in check; try Debitize, which automatically pulls money from your checking account when you swipe your credit card, and then makes your payment in full for you at the end of the month.

Don’t want to end up like the average household, with $8,180 in credit card debt and mediocre credit? Then don’t follow the average path of jumping into credit cards without first learning how to use plastic responsibly.