Debit Cards vs. Pre-Paid Cards vs. Credit Cards
- Credit cards are an excellent option for building a credit history.
- Debit cards ensure you don’t spend more than you have in your account.
- Prepaid cards are a good option if you don't have a bank account.
Credit cards and debit cards seem indistinguishable at first glance. However, both have a 16-digit card number, an expiration date usually three to five years out from the card's issue date, and a chip and magnetic stripe that can be inserted into a card reader. Credit cards and debit cards also offer convenient ways of making purchases and are certainly much safer than cash, which can be stolen or damaged, with no ready means of replacement.
There are some important differences to be aware of as you weigh which type of plastic to carry. But first, let’s dive into the basics of understanding the differences between debit cards, credit cards, and prepaid cards.
Debit cards come in two categories:
- A traditional debit card is linked to your bank amount
- A prepaid card has a certain amount of money that is loaded on the card in advance.
What is a debit card?
A debit card is a payment card that withdraws money directly from your account when you make a purchase. Debit cards allow you to purchase goods and services at a store or online and allow you to obtain cash by withdrawing funds from an ATM machine.
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What is an ATM machine?
According to Bankrate, an ATM (Automated Teller Machine) is a specialized computer that makes it convenient to manage a bank account holder's funds more convenient. An ATM also allows a person to check account balances, withdraw or deposit money, print a statement of account activities or transactions, and even purchase stamps.
The cash-withdrawal feature of debit cards leads many banks to provide customers with a debit card as soon as a checking account is opened rather than providing an ATM card.
How much can I withdraw from my debit card?
Since debit cards withdraw money directly from your bank account, the associated credit limit is your account balance. So, for example, if you have $10,000 in your bank account, your debit card limit is also $10,000.
Bank account balances can fluctuate daily, with the rhythms of salary deposits, utility payment withdrawals, and other expenses. As such, the amount available on a debit card can vary daily. In addition, debit cards usually have a daily purchase limit, meaning you can’t spend more than a certain amount on the card within 24 hours. This differs from credit cards, which often have no daily or time-based spending limit.
What are the costs associated with having a debit card?
Debit cards typically don’t incur an annual membership fee, but depending on the bank, monthly maintenance fees may be associated with your debit card. Your funds are withdrawn directly from your bank account as soon as you make a purchase. There aren’t any interest charges to your bank account when using a debit card, but an overdraft fee could apply. An overdraft fee can occur if you withdraw more money from your bank account than you have stored.
Furthermore, if you decide to withdraw money from your account at an ATM machine then you will most likely get charged an ATM fee, which could be around $2.50 or more, unless your bank has a reimbursement policy for ATM withdrawals.
Lastly, since debit cards function like an ATM cards in terms of being directly linked to your bank account, there are no cash advance charges. This differs from a credit card, where cash advances incur a fee and interest as you borrow funds from the credit card issuer.
Prepaid Debit Cards
Prepaid debit cards, much like debit cards, are issued by banks and branded by major credit card companies. However, prepaid cards are not linked to a bank account, unlike debit cards. Generally, when you use a prepaid card, you are spending money that you have already loaded onto the card. In this regard, prepaid debit cards are beneficial for sticking to a budget.
While overspending can occur with a credit card, to the tune of thousands and even tens of thousands of dollars, depending on your credit limit, with a prepaid card, spending can only occur to the limit of how much you’ve loaded on the card. Thus, for vacations, holiday spending, or other activities where you might be tempted to spend beyond your intentions, a prepaid card helps you stick to a predetermined figure.
If you’ve never used a prepaid debit card but used a gift card, then you’re already well-familiar with how prepaid debit cards work. A prepaid card allows you to spend whatever amount of money is stored on the card. Then, once the balance is used up, you can reload the card online or at a participating store, just as you would with a gift card, and continue spending on it.
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A credit card is not linked to your bank account. So, when you make purchases, the purchase amount reduces your available balance up to the level of your credit limit until the amount owed is repaid. For example, if your credit card has a $2,000 credit limit and you make purchases totaling $500, your available balance will decrease from $2,000 to $1,500.
What are the benefits of having a credit card?
Credit cards offer several benefits in comparison to debit cards. Perhaps the biggest benefit is that with a credit card, you are borrowing someone else’s money, specifically the bank or retail store that provided you with the card, rather than your own money.
Granted, the loan is only 30 days, after which you must pay back the borrowed amount, often with interest. But, if you pay off your credit card balance on time and in full every month, then credit cards, particularly those with no annual fees, can serve as interest-free, one-month loans.
Credit cards also enable you to build your credit score, generally determined by FICO, by showing that you pay your debts on time. In addition, your credit history serves as an indicator to banks when considering the interest rate, fees, and other terms for larger purchases such as car loans and mortgages. But with these benefits come risks and a need for caution when using credit cards.
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What are the risks of using a credit card?
The biggest risk of using a credit card is that you might borrow more than you can pay back. If your credit card is viewed less like a short-term, high-cost loan and more like a piggy bank dispensing free money, it can be easy to find yourself reaching the top of your credit limit very fast. Once you’ve maxed out your card, it can be challenging to pay back the balance quickly.
The second risk of using a credit card is the high-interest rates. The average credit card interest rate in the United States (U.S.) is approximately 21%. To put this in perspective, imagine that you have a credit card with a balance of $5,000, which is slightly less than the average credit card balance in the U.S., and that you’re making a payment of $100 a month. At this payment rate, it will take you 120 months, or ten long years, to pay off the debt.
But wait a second, why is it taking ten years? After all, $5,000 divided by $100 should mean that the debt is put to bed in 50 months or a little over four years. This is where the credit card’s interest rate, also called the Annual Percentage Rate (APR), comes into play. An APR rate of 21% adds a whopping $6,996 of interest to your payment, turning what was a $5,000 debt into an almost $12,000 one. As such, credit cards must be used carefully and in line with your ability to repay them.
A good rule of thumb is to borrow no more than 30% of your credit limit and to pay the bill off on time and as close to in full each month as possible. Note that we didn’t say don't use your credit card at all. Some usage is required to establish your credit history and provide lenders with an indication of your ability to repay larger loans down the road.
The Money Wrap-Up
Credit cards, debit cards, and prepaid debit cards can all be used to make purchases. The best choice depends on your spending goals and what you want to get out of the card.
A credit card is an excellent option for building a credit history. However, spending must be carefully controlled to ensure that balances can be paid on time and in full. Debit cards are a great way to have the convenience of plastic coupled with controls to ensure you don’t spend more than you have in your account. Finally, prepaid cards are a good option if you don't have a bank account or want to ensure that you spend no more than a set amount when using them.