banking

The dangers of prepaid debit cards

Nikiforos T. Laopodis, Ph.D.Some consumers are considering dumping their bank and instead using prepaid debit cards as an alternative to a traditional checking account. The reasons for doing so vary, but convenience and a desire to control spending are among the top motivators.

However, the decision to embrace prepaid debit cards can be fraught with danger, according to Nikiforos T. Laopodis, associate professor of finance at Fairfield University's Dolan School of Business in Connecticut.

Laopodis says high fees and lack of government regulation are among the factors that make prepaid debit cards riskier than some people might think. He outlines his thoughts in the following interview.

What's the difference between a prepaid debit card and a credit card?

A prepaid debit card is not a credit card, mainly because it does not require background credit checks for the applicant, charges no interest on unpaid balances, has spending limits that cannot be exceeded (compared to a credit card, where you can exceed the limit but will pay a penalty), no supporting bank account is needed, and it cannot be used for building credit history.

Why are consumers flocking to prepaid debit cards right now?

Various reasons, both economic and noneconomic. Consumers may not have secure (adequate) credit history, or may have no history at all. Prepaid debit cards are a convenient alternative to credit cards, debit cards and checking accounts. There are heavy promotions by both banks and celebrities. There is the ease of use for purchases overseas. They are easy to set up and immediately use. And because people wish to control their spending (and avoid getting into debt -- but that is illusory, as we will see later).

How are consumers using prepaid debit cards -- as a replacement for a checking account, or for some other purpose?

They are used for various purposes, such as bill payments, online and store purchases, and as a replacement to checking accounts, debit cards and credit cards.

Are prepaid debit cards a viable alternative to checking accounts?

For many consumers they are, but for others they are not. For example, prepaid debit cards have higher fees for dispensing funds compared to checks, prepaid cards have no dangers of revealing checking account information (as printed on checks) because there is no underlying account, and there is no need to carry a check or checkbook with you.

If you have a high-fee checking account, discuss the situation with your bank to work something out for you rather than rush into prepaid debit cards.

What are the dangers of prepaid debit cards for consumers?

There are many dangers with prepaid debit cards. People do not learn to manage their finances by using such cards compared to using a checking account, for example. A properly managed checking account will offer many benefits in the long run, such as debt discipline, needed credit building (along with a properly used credit card), zero (or minimal) expenses and so on.

Other dangers include the exorbitant and various fees associated with such cards (compared to a credit card, debit card or even prepaid credit card, which is a better option than a prepaid debit card). For example, the fees could be for activation, usage, ATM use, reloading, service assistance, maintenance, inactivity and so on. Basically, it depends on the imagination of the banks!

In addition, other dangers include the inability to exceed the spending limit if and when needed, no comprehensive government regulations currently in place (some regulations do exist, however, but offer incomplete protection to consumers; check with the Federal Deposit Insurance Corp.), and many more.

Are there any advantages to prepaid cards over checking accounts?

As these cards are currently set up, there are no real advantages over regular checking accounts because of the high fees associated with such prepaid cards.

For example, when you set up an automated monthly pay system for bills, a checking or other bank account (if no credit card is available) is required. Withdrawing funds from the checking account (if properly maintained) incurs no fees or charges.

But using a prepaid debit card, the fees to reload and maintain it on a monthly basis could be prohibitively high.

What should you look for when choosing a prepaid card?

Banks target people with no credit history, with low income, and no bank accounts to sell these products. The consumer must be educated and smart.

A prepaid debit card inquirer should at least decide why and for how long to use the prepaid debit card, compare the banks that offer such products, not fall for fancy advertisements or friends' advice, and finally, and most importantly, always read the fine print. If you cannot understand it, get someone to read and explain these to you.

We would like to thank Nikiforos T. Laopodis, associate professor of finance at Fairfield University's Dolan School of Business in Connecticut, for his insights. Steve Pounds, senior editor for Bankrate.com, contributed the questions for this interview.

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