Avoiding credit-builder card pitfalls

By Michael Lloyd

You may have heard advice to take out a "credit-building card" if you have a low credit score. These low-limit, high-interest are cards aimed specifically at people who are considered high risk, and who likely have poor credit. However, if you don't spend and repay responsibly, the credit-building card can leave your score even worse off than before.

It doesn't help that lenders are seemingly encouraging high-risk borrowers to take on debt. A 2016 Daily Mail article stated that some lenders are relaxing their lending criteria, while charging exorbitant interest rates of up to 60% APR. A survey by debt charity StepChange revealed that 11% of respondents asked for help with financial difficulties and their creditors raised their credit limits in response.  

Only you control your spending. There is no reason you should get into difficulties, even as a high-risk borrower with a credit-building card, as long as you know how to use the credit you get wisely. credit-building-pitfalls

Wise borrowing starts with the application
While it's true that high-risk borrowers have a lot less choice in available credit cards than those with optimal credit scores, you shouldn't necessarily go for the first credit-building card offer you come across, even if it seems to be offered specifically to you.

According to research from the Financial Conduct Authority, almost a third of new account holders in the higher risk segment are secured via direct mail propositions. Even if an advertisement comes to you in the mail, check out what else is available before making an application.

The most important thing to look for is the interest rate, or APR. While you should aim to never carry a balance, especially if you're trying to build credit, making sure you're on the lowest rate possible will save you money should you have to. You can also look for annual fees or income minimums.

Mainstream lenders such as Barclaycard and Capital One offer credit-building products, and often charge less interest than issuers that specialise in servicing high-risk customers. In addition, some mainstream lenders provide soft search tools that can tell you the likelihood of being accepted without making a hard pull on your credit score.

"If you do go for a credit card to help build your credit, choose one with a reputable bank, and one with the lowest interest rate you can secure," Richard Holmes, B2B marketing manager at debt advice service PayPlan, said in response to emailed questions.

Continue wise habits as you use your card
If you're serious about improving your credit via a credit-building product, the way you manage your account is crucial.

Going on a spending spree and carrying a balance will cost you money -- perhaps excessively so, depending on your interest rate. It could also result in missed payments and credit limit breaches, which lenders may report to credit reference agencies, thereby hurting your chances of getting credit in the future. 

"It is essential to avoid the pitfalls associated with a rolling balance -- any amount not paid off at the end of the month will incur heavy interest charges which can become increasingly hard to pay off, and, of course, harm your credit score," Holmes said. "Pay off your credit card borrowing on time and in full each month -- this will help rebuild your credit history and avoid spiralling debts."

A good way to use a credit-building card is to charge a small, set amount on it every month and set up a direct debit to clear your full balance. A subscription or set monthly bill are two good examples.

The benefits of this include building up a positive repayment history and keeping a low credit utilisation ratio (which is the amount of credit you use compared to the amount of credit available to you). Both of these things factor into your credit score. Additionally, clearing your balance each month will prevent interest.

If you do use your card for other purchases, be sure you don't spend more than you can immediately pay back, or at least what you can pay back in a reasonable timeframe. If you're going to make a larger purchase, have a plan to pay it off before you charge.

Taking out a cash advance with your credit card is always inadvisable, even on a prime credit card, as interest will apply on anything you borrow from the moment you get the money. Many credit-building cards also charge a fee of up to 60% for cash advances, making it an extremely expensive way to borrow money.

A credit-building card can easily open the door to becoming a prime borrower, but they can just as easily be a door to debt.

See related: Rebuild your score with a credit-building card, The hidden fees and charges in your card agreement

Updated: 22 May 2017