Debit cards and credit cards are probably the most convenient way to carry money without having to carry any money. They look similar, are accepted universally, and make for light travel (and lighter wallets). But carrying a credit card is like getting a small loan - when you use a credit card, the bank fronts funds to consumer credit (a loan). In other words, you basically ask the bank to lend you the money you don't have, but promise to repay in a month when you receive the credit card bill. A debit card, on the other hand, withdraws directly from your bank account, i.e. draws on existing funds.
|Where money comes from||Borrowing money from a bank or financial institution. (Spending "other's" money)||Funds taken from the money that you have in your bank account. (Spending your "own" money)|
|Can be used as||Credit card only||Debit or credit card i.e., a debit card may be used without a PIN for certain types of transactions such as e-commerce.|
|Line of Credit||Carries Line of Credit||No Line of Credit|
|PIN Number||Usually not. However, some credit cards may provide PINs to allow consumers to withdraw money from ATMs just like debit cards. Such withdrawals are generally a bad idea because they carry high fees and interest rates.||PIN number provided, but not always asked to punch in.|
|Picture ID required before issuance||Yes||No|
|Interest||If a credit card bill is not paid in full, interest is charged on outstanding balance and the interest rate is very high.||No interest is charged because no money is borrowed. Consumer's own funds are used to make purchases.|
|Credit History||Responsible credit card usage and payment can improve one's credit rating. Credit cards typically report account activity to at least one of the three major credit bureaus on a monthly basis.||Does not affect credit history.|
|Legal Liability laws||Strict. Consumer liability limit for credit card fraud is $50 if the credit card company is notified within 60 days in written since the fraudulent charges.||Lean. Consumer liability limit for debit card fraud is $50 if the bank is notified within two days of noticing the fraudulent charges.|
|Risk involved||Low. Consumers are protected against unauthorized purchases as long as the fraud is reported in a timely manner. Consumers are not responsible for charges incurred in fraudulent transactions.||High, as they are attached to a bank account. A person does not need a PIN number to use a debit card and therefore can easily drain a persons bank account, causing extreme problems.|
|Fraud||Only problem is proving that someone else has used the card.||With a debit card the person has to figure out how to get their money back and if any checks bounced they are responsible for those as well.|
|Limit||Credit line, which can be increased/decreased from the time of applying.||Equals your account limit.|
|Overdraw Fees||Low. Some credit card companies allow to overdraw amount over the maximum credit line with a fee.||High "overdraft" fees. Possible to overdraw amount over the account limit|
|Connected to||Need not be connected to any bank account.||Checking or Savings Account|
|Offers protection and other benefits||Often. For example, extended warranties on new products, or insurance on a rental car.||Sometimes. For example, extended warranties on new products, or insurance on a rental car.|
Advantages of Credit Cards
Credit cards are useful when at the time of purchase, you either don't have enough money or do not want to pay all the money immediately. If you pay your bills on time, a credit card is like an interest-free loan from the time of purchase up until the bill payment due date.
Many credit cards also offer rewards such as cash back, travel, discounts at retailers, and value-added services like concierge.
The advantage for merchants accepting credit cards as a form of payment is that they tend to increase sales because:
- Credit cards are convenient, especially for large amounts (where cash is inconvenient); and for internet-based transactions.
- Since consumers using a credit card are not really paying out of funds they have in a current account, and they do not have to pay until a few weeks after the monthly bill arrives, they tend to spend more freely.
Advantages of Debit Cards
Debit cards allow consumers to live within their means. Since funds are drawn from an account where you have already deposited money, and the amount of funds you can use is typically only to the extent of your account balance. Some financial institutions allow overdrawing but there are penalties associated with it. The financial legislation passed in the US in 2010 also makes changes to whether financial institutions allow overdraft by default and the associated penalties and fees.
The advantage to merchants is that fees paid to payment processing firms like Visa and Mastercard is lower for debit cards than for credit cards. This is also addressed in the financial regulation passed in the US in 2010, which seeks to lower and limit transaction fees for debit cards.
Disadvantages of a Credit Card
Interest Rate on Outstanding Balance
The big money for financial institutions lies in debt. When consumers do not pay their credit card bill on time, the outstanding balance begins to accrue interest and the interest rate that credit card companies charge are usually very high. That is why financial advisors and debt counselors typically advice people to get rid of credit card debt before any other kind of debt.
Credit cards make it easy for people to spend beyond their means because payments are not due immediately. Credit card bills have a "Minimum Payment Due" which lulls consumers into a false sense of complacency, as they do not feel bad if they only pay the minimum and not their entire bill. This can lead into a debt trap if one is not careful, as the interest rate on outstanding balances is significantly high.
Some credit cards charge an annual fee for using it. These are mostly credit cards that offer rewards, especially cash back or travel rewards. Their claim is that the rewards are so good, that if used well, they will more than make up for the annual fee. The annual fee is often waived for new accounts.
Disadvantages of a Debit Card
The good news is that because a debit card takes only from the money you already have, you tend to spend within limits. However, if you run out of funds in the checking account linked to your debit card, there is an unforgiving overdraft penalty for spending more than what you have.
Debit cards usually do not have annual fees associated with them. Typically, debit cards are offered free with all checking accounts, especially with new accounts. Prepaid cards are a special type of debit cards that do not require an account balance. In that sense, they are like gift cards. There is usually a fee associated with such cards, in spite of the fact that the financial institution offering the card will make money on:
- the interest on the money you deposit for the card.
- transaction fees collected from merchants where you use the card.
Types of Credit Cards
Some of the most common types of credit cards are:
1. The Standard Credit Card: These are general purpose credit cards with revolving balance (i.e. credit is used up when purchases are made, and is open again once the bill is paid). Standards cards are usually starter credit cards, usually for applicants with little or no credit history who meet the minimum required criteria.
2. Reward Credit Cards: These cards offer several rewards programs in the form of cash, points or discounts, and are intended to influence your spending. Reward cards usually come with an associated annual fee and a lot of fine print; the key is to make sure the rewards earned exceed the annual fee.
3. Secured Credit Cards: Also known as pay-as-you-go cards, their primary purpose is to give people with bad credit history a chance to reestablish credit. The user first deposits a "secure" amount (say $300-$3000), which makes for the credit line. The credit limit is usually a percentage (50%-100%) of this amount. These cards come with an annual fee and a high APR.
4. Charge Cards: Charge cards do not have a preset spending limit and balances must be paid in full at the end of each month.
Types of Debit Cards
Debit cards are of the following types:
1. PIN-only cards: PIN-only debit cards are linked to your bank account and can be used for cash transactions and fund transfer, buy from retailers and pay bills online or by phone. The card holder is required to enter a secure PIN for every transaction to establish identity and maintain security.
2. Dual-use cards: Dual-use debit cards are both signature- and PIN-enabled, and tied directly to your bank account. You can verify your identity either by signing or entering your PIN.
3. EBT cards: Electronic Benefits Transfer (EBT) cards debit cards provided by a state or federal government agency to users who qualify for food stamps, cash payments, or other benefits. EBT cards can be used to make purchases at participating retailers or to withdraw cash from an ATM, depending on the type of program.
4. Prepaid cards: Prepaid cards are not linked to a specific account, but provide access to funds deposited directly on the card by you or a third party. In effect, they work as a store-credit or gift card.