Credit versus Debit Cards

For many of us, the years of carrying around a significant amount of cash are long gone. No more sitting on an uncomfortably fat wallet, instead we started to carry credit cards, a lot of them. Over time, we didn't want to carry "specialty" credit cards anymore; we wanted to streamline our monthly payments. Today, we're really down to two choices: a credit card or a debit card.

In this publication, we're going to talk about the differences between debit cards and credit cards.  As part of that discussion, we'll talk briefly about the history of each card type.  Next, we'll explain what it means to pay for something using credit versus debiting an account.  Then we'll finish up with the advantages and disadvantages of each card.

Credit Cards and Debit Cards

Selling merchandise on "credit" has been around for many years.   Customers would receive goods or services with the promise to pay for them at a future point in time.  The modern-day credit card was first used to sell automobile fuel to consumers back in the 1920s.  It wasn't until the 1960s when the plastic cards we know today were mass marketed.  Bank of America would first launch what was to become a "Visa" card.  Several years later, "MasterCard" was launched to compete with Visa.

The history of debit cards, also known as check cards and bank cards, is less clear.  Research indicates the first debit card appears to have been issued by the Bank of Delaware back in the 1960s.  Cards became mainstream in the 1970s, and widespread use took hold in the late 1980s.  While the introduction of debit cards coincides with credit cards, use by consumers was slow to develop, but rapidly accelerated in the early 2000s.

Credit and Debit Card Merchant Fees

The popularity of credit cards grew out of consumer convenience and merchant acceptance.  Consumers no longer had to worry about carrying large amounts of cash to pay for goods and services.  Merchants liked the concept too.  They no longer had to worry about handling as much cash, but they also benefited from impulse purchases by consumers too.

Generally, merchants prefer debit cards to credit cards.  All cards are subject to what are called interchange or transaction fees.  These fees are the "cost" of transferring funds between the merchant bank and the customer's bank (card issuer).  Companies like Visa determine these fees, which often involve a fixed and variable component.  For example, the interchange fee might be $0.25 per transaction plus 2% of the purchase price.

Merchants prefer their customers use debit cards.  That's because the interchange fees for debit cards are usually lower than credit cards.  The higher interchange fees associated with credit cards allow financial institutions to profitably market offers such as 1% cash back rewards.

Paying by Credit versus Debit

The "behind the scenes" difference between using a credit card and a debit card is very straightforward, and knowing how they differ will lead us right into a discussion of the pros and cons for each card type.

• Credit Cards:  a credit card allows the user to make a purchase using money "borrowed" from the card issuer.  If the money is paid back in a certain timeframe, the user essentially gets an interest-free loan.
• Debit Cards:  a debit card is directly linked to a bank account.  The money spent using a debit card is immediately deducted from the account balance.

Advantages of Credit Cards

• Convenience - with a credit card, you don't have to worry about carrying around a lot of cash.  If you see something in a store that you want to buy, you can just charge it to your credit card.
• Interest-free Loans - if you pay off your card's balance each month on time, then you're getting an interest-free loan of money.
• Credit Rating - using a credit card in a responsible manner tells lenders you can be trusted to pay back borrowed money.
• Rewards - most credit cards offer cardholders reward programs, sometimes referred to as affinity or loyalty programs.  Popular rewards include airline frequent flyer miles, cash back, and gift certificates.
• Liability - if a stolen or lost card is reported to the issuing bank in a reasonable timeframe, the cardholder's liability is limited to $50 in fraudulent charges.
• Dispute Resolution - until a dispute is resolved, a cardholder can legally withhold payment to a vendor if they are dissatisfied with a transaction.

Disadvantages of Credit Cards

• Overspending - if not used in a disciplined manner, a consumer can quickly find themselves with a large amount of credit card debt.
• Credit Rating - if a pattern of late payments emerge, the cardholder's credit score may be negatively affected.
• Fees - many credit card issuing companies offer low initial interest rates on account balances, which are sometimes referred to as teaser rates.  Over time, these fees can increase and will add considerably to the cost of borrowing money if the card balance is not paid-in-full each month.

Advantages of Debit Cards

• Convenience - with a debit card, you don't have to worry about carrying around a lot of cash.  If you see something in a store that you want to buy, you can use your debit card to pay for the item.
• Control - a debit card gives the cardholder more control over their spending patterns.  There is more real time feedback when the card is used; debit cards are not subject to the overspending abuse that can occur with a credit card.
• Fees - since the debit card is funded by money in the cardholder's account, fees such as interest charges would not apply.

Disadvantages of Debit Cards

• Overdraft Fees - if selected, some debit card issuers offer overdraft protection.  If used, these over-limit fees will add to the cost of carrying a debit card.
• Blocks - merchants can place a block on the account, reserving funds until a transaction is completed.  These blocks can trigger overdraft thresholds.  For example, a gasoline station may block $100 on the account before the transaction is completed.
• Liability - even if a stolen or lost card is reported to the issuing bank within two days, the cardholder's liability can be as high as $500 in fraudulent charges.
• Dispute Resolution - since the merchant has already received the money for an item, the cardholder has very little leverage if a dispute over the transaction arises.

Final Thoughts:  Credit or Debit

If used responsibly, the choice is simple.  Credit cards are not only convenient, but are also offered with features such as reward programs and consumer protections that debit cards cannot match.  Why are debit cards growing in popularity?  It really comes down to discipline.

If abused, a credit card holder will eventually find themselves deep in debt.  When multiple credit cards are used to support an overspending habit, the cardholder can find themselves with tens of thousands of dollars in debt.  Debit cards allow these individuals to regain control over their spending habits, and consume responsibly.

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