You’ve likely been asked the question “debit or credit?” during purchases thousands of times over the years.
Most people decide whether to use a debit or credit card before the cashier even gets a chance to ask. But do consumers really know the difference between the two spending options? Moreover, which plastic card is the better payment option?
Credit cards and debit cards look similar and function almost the same way. The fundamental difference between the two is the reserve of money from which each card pulls funds.
How do debit cards work?
Debit cards are linked to a personal checking account meaning the amount you can spend with your debit card is limited by the amount of cash you have in the bank.
There is no application process involved with debit cards. Debit cards are automatically provided when you open your checking account to complete simple transactions such as withdrawing cash from the account or making everyday purchases.
While paying with a debit card may feel the same as using cash, there is a slight difference which could lead to issues of overdrawing on your reserve of funds.
A debit card pulls funds directly from your checking account during a purchase by placing a hold for the exact amount. The merchant’s account (the seller you’re buying goods or services from) sends the transaction to their bank, and the money is transferred from the buyer’s account (your account) to the merchant’s account. This transaction can take anywhere from 24 hours, to a few days, to completely process.
For this reason, it’s important to keep an eye on the running balance of your checking account or monitor the account through a smartphone app to make sure that you don’t spend more than you have in your account. This prevents the accidental overdraw of funds and avoids the heavy fees associated with being overdrawn on a checking account.
How do credit cards work?
Credit cards begin with an application process. In that application process, the credit card issuer will review a person’s credit history and credit score.
After an individual is approved for a card, a line of credit is extended to a customer by the credit card issuer. This line of credit is a monetary amount based on factors such as a customer’s financial history, credit score, and their current income, which are all factors the credit card company uses to assess the likelihood that the customer will be able to pay back their line of credit.
Making purchases with a credit card is essentially borrowing money from a lender that must eventually be paid back. This revolving credit replenishes when you make a payment towards the total debt balance.
Advantages and disadvantages of debit cards
Debit cards are more manageable for budgeting purposes and spending control. These cards are especially helpful for younger people or individuals looking for help to get spending habits under control. Unlike credit cards with credit lines, once a checking account is depleted of money, a user is unable to spend any more until another deposit hits the account.
Debit cards have a distinct advantage over credit cards in their ability to put cash in a users hand in a much quicker fashion. Debit cards linked to checking accounts typically come with physical checks that are necessary for making payments to some organizations, like schools and youth sports leagues.
While debit cards do not have interest fees on purchases (so long as you don’t go overdrawn), there are fees users may accrue during simple transactions. Some checking accounts get dinged with fees for using ATMs not associated with the bank. If the ATM also charges a fee, users can get walloped with double withdrawal fees.
A few banks will also charge a maintenance fee if the amount in the checking account dips below a certain number.
Prepaid debit cards are another purchasing option with even less risk than the standard bank-issued card. Prepaid cards are easy to obtain, usually, they don’t involve a credit check, and are a safe option when denied a bank account because of poor banking history.
Advantages and disadvantages of credit cards
There are numerous advantages to choosing credit cards for daily and monthly purchases. Credit cards often offer rewards in the form of cash back, points, or miles on every purchase you make with your card. There are a lot of credit cards offering generous rewards programs that multiply your returns on everyday spending, and some that give higher rates of rewards based on specific activities, like eating out or using an airline’s co-branded card when booking travel. Depending on what credit card you have the rewards you earn can usually be redeemed for things like statement credit, cash back, gift cards, and on travel.
Using a credit card and paying off what you owe each month each month keeps an individual’s credit score healthy. Financial institutions deem customers with high credit scores a lower risk — meaning, based on the customer’s previous financial behavior, there’s less chance they will default on what they owe. Companies will offer larger spending limits at lower interest rates based on this numerical score.
Credit cards help customers build a credit history. This leads to better loan rates and other financial incentives in the future. Failing to pay your credit card balance in full each month causes users to fall into debt. This debt negatively impacts your credit score and could spell trouble down the road.
Credit cards hold a distinct advantage over debit cards in the instances of fraud protection and card theft. Most major credit cards offer extensive consumer protection and payment protection in instances of fraud. For debit cards, stolen cards and misused funds are much harder to prove and customers must often accrue the losses associated with fraudulent purchases. According to the Electronic Funds Transfer Act (EFTA), customers have up to 60 days to report a lost or stolen card. After that, victims of theft lose whatever money was taken.
There are some credit cards that come with additional insurance features such as price protection, extended warranties, and travel insurances like lost luggage or trip cancellation. While it’s necessary to closely study the fine print to see what you’re covered for, your credit card can often save you on insurance expenses.
The biggest disadvantage of a credit card results from not paying off what you owe. If you don’t pay down your balance you will be paying very high rates of interest. Annual percentage rates (APR) on credit cards can be as high as 29% (depending on your creditworthiness) and interest expenses can quickly get away from you. However, as long as you stay on top of your payments, you may never pay a penny in interest and still get all of the advantages of having a credit card.
Which is the better payment option?
In most cases, a debit card is a necessity and comes standard with a checking account. Credit cards are not a necessity though it is essential to have at least one open line of credit in order to build a credit history to make applying for other loans, such as financing a car, renting an apartment or applying for a mortgage, much easier.
For some people, a debit card may be all you need, but most people can benefit from the credit-building and additional perks offered by credit cards.
Credit cards can offer a host of additional benefits like cash back rewards, travel rewards, payment protection, and insurances. If you use your credit card for all of your purchases you will accrue rewards on every dollar you spend, for instance, on some categories you could earn as much as 5% cash back. So long as you pay off your balance as soon as possible to avoid interest charges and accumulated debt that may be harder to eliminate down the road.
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