I've finally broken through the writer's block that has been shutting me down for a few weeks, so I thought it would be a good time to turn to a discussion of credit and debit cards. In the past I have never been shy about expressing my opinion that credit cards are vastly superior to debit cards. However, to be fair, this is not always the case for every person. Depending on how and where you use your cards, debit cards can have some advantages. Follow me down for a detailed examination of which card is better and why.
Fraud Protection
If your credit card is stolen or used fraudulently, you are not responsible for these charges. (With some cards, you may be legally liable for up to $50 of fraudulent charges, but Visa and Mastercard both have policies that make you not liable for anything.) All you have to do is make sure to report your lost card as soon as you notice it and then contest the charges you see on your bill. Debit cards have a similar fraud protection policy, in theory, but the practice can be much worse for the consumer. Firstly, there is that $50 limit that you are now legally liable for. Secondly, the big difference is that when a fraudulent debit card transaction is processed, the money is immediately deducted from your account. You may, in the end, be able to convince the bank that you are not responsible for this charge (or you may not) but while you are debating the matter, you don't have your money. This can be a huge problem if you are talking about a large sum of money, or even a relatively small sum, if you are living close to the edge.
Advantage: Credit Cards
Merchant Fees
Although debit and credit cards may look very similar and be used in very similar fashions, there is a lot of difference behind the scenes. This distinction is somewhat muddied by the fact that a debit card can be treated as a credit card by a merchant, and still be treated as a debit card by your bank. When a merchant processes a credit card transaction (whether or not the piece of plastic is labeled "debit card") they pay an interchange fee. Here's a handy picture of from the Government Accounting Office that explains this fee:
On a $100 transaction, the merchant pays a fee of about 2%. This rate is not a fixed percentage and can vary for different merchants, for different cards and for different purchase amounts. (Update [2010-4-16 18:41:0 by sarahnity]: I just realized I left the "not" out of the previous sentence. Kind of important.) However, debit card transactions (where you type in a PIN for the merchant, rather than signing your signature) are handled by a different network (the same networks that handle ATM transactions, incidentally). This transaction is much less costly to the merchant, usually the fee is around half the credit card interchange fee. The more the merchant has to pay to accept credit cards, the higher the prices will have to be to compensate for this.
Advantage: Debit Cards (when used with a PIN)
Merchant Rewards
Because debit card required a second network for merchants to subscribe to, initially some of them would charge a small fee to use a debit card. However, these fees have mostly disappeared, and now merchants are often trying to encourage customers to use debit rather than credit, since it is ultimately cheaper to the merchant. This encouragement can take the form of discounts or coupons that only debit card users can receive. Ikea is one merchant that when you pay with a debit card, they will print out a coupon at the bottom of your receipt for a discount on your next purchase.
Advantage: Debit Cards (occasionally)
Bank Rewards
Because banks can make so much profit on these interchange fees, they have a strong incentive to encourage customers to use their credit cards as often as possible. This encouragement usually comes in the form of purchase rewards that can be used as discounts or even cash back. I find cash to be the best reward of all and there are some cards that give very high rewards that in essence return to you pretty much the entire fee the merchant paid.
Advantage: Credit Cards
Free Float Loan
When you make a purchase using a credit card, you don't have to actually pay the bill for about 30 days from the time of purchase. This means that you are in essence using the bank's money interest free for that amount of time. With debit cards, you pay for your purchase immediately and miss out on that benefit. Keep in mind that if you fail to pay your balance in full each month, this loan goes from being a nice benefit for you to a big penalty.
Advantage: Credit Cards
Staying Within Your Budget
Studies have shown that on average, people tend to spend more when they use credit than when they use cash. When debit cards are treated like cash in the mind of the user, this effect may be negated. If you are someone whose spending motto is "when I run out, I'll stop" a debit card can be a huge help in keeping you within your budget. There is one huge caveat to this approach, however, and that is the existence of overdraft protection (see below).
Advantage: Debit Cards
Overdraft Fees
Overdraft protection is only "protection" in the sense of a mafia racket. This is where your bank, when presented with a charge you can't pay, will kindly let the charge go through, and then charge you some outrageous fee for the privilege. So instead of having your card declined at Starbucks, you get to pay $30 for a cup of coffee. Isn't that nice of them? No. No it's not. The best part is that banks can enroll you in debit card overdraft protection without you even being aware of it. You may have no idea until you see the fees on your statement. Under the credit card reform laws that have recently gone into effect, credit card companies can no longer charge you such fees, unless you have explicitly agreed in advance.
Advantage: Credit Cards
Emergency Loans
Bad stuff can happen to anyone: an emergency medical bill, an unexpected car repair or some other expense you just didn't expect but can't delay paying. This is why it is best to have an emergency savings fund of a few months salary that you can draw on at any time, but not everyone is able to build that up, particularly in today's economy. If you don't have access to a savings account for emergency expenditures, credit cards can be a lifesaver.
Advantage: Credit Cards
Cash Advance or ATM Fees
Getting cash from a credit card is usually going to be a costly effort. You are probably going to have to pay a cash advance fee and, in addition, ATM fees paid to the ATM provider. Debit cards, on the other hand, also function as ATM cards so as long as you are using an ATM that is within your network, you can get access to your cash for free. If you are looking to get some cash from your credit card for free, many merchants offer you the option of getting cash back at the time of purchase.
Advantage: Debit Cards
Merchant Holds
There are some merchants who don't know exactly how much your final bill will be until after they have given you the product. Hotels, rental car companies and gas stations are all in this category. In order to ensure that your credit is good, they will often put a hold on a large amount at the beginning of your transaction and then release that hold at the end. Unfortunately, that release doesn't always get processed as quickly as the initial hold was. In addition, in the case of hotels and rental cars, that hold may be in effect for many days. If you have a debit card, that means that you may not have access to a big chunk of your funds for an extended period of time. With credit cards, that hold is usually transparent to the user. As long as you are not charging near the limit of your available balance, you won't even notice it.
Advantage: Credit Cards
Credit Score
If you are trying to build a credit history, a debit card is virtually useless. A credit score essentially is a measure of how well you have paid your bills when you have borrowed money. Since a debit card doesn't involve any borrowing, it doesn't help. If you want to build your credit history, you need to take out credit. However, taking out too much credit, or using it too much, can hurt you. Your credit score can take a hit if you routinely carry charges up to or near the credit limit on your card. This is true even if you pay this balance off in full every month. Having lots of credit, but not using it much is actually the most beneficial to your credit score.
Advantage: Credit Cards (when used in moderation)
Who Wins Overall
The bottom line is that if you are the kind of shopper who can stick to a budget and only charge what you can afford to pay off in full each month, a credit card is a big win for you. If you have an ATM card for your checking account, make sure that your bank either issues you a card that cannot be used as a debit card, or have them turn that feature off.
If you do have a good reason to use debit cards instead of a credit card, try to limit your fraud liability by linking that card to an account separate from your main checking account. Keep a limited amount of money in your debit card account and make sure that you have turned off and declined any overdraft protection schemes your bank may offer. Even if you don't want to use a credit card routinely, it's not a bad idea to have one in addition to your debit card. Use it when you rent a car, stay in a hotel and keep it in reserve for those emergency expenses that you hope don't come up. Just having a card that you occasionally use for small purchases will help build your credit rating as well.