What’s the difference between a debit and a credit card?
Although both debit and credit cards are common financial tools used to make purchases, the differences between them and the potential impact to your finances may not be as clear.
You’ve probably heard about the issue of consumer debt in this country, which includes a great deal of credit card debt. In fact, households with a credit card carry an average of $8,398 in credit card debt.
On the flip side, while you don’t hear about debit card debt, they also carry some drawbacks you need to be aware of.
The following paragraphs will discuss the major differences between a debit and a credit card, as well as which one may be right for you.
For our more seasoned readers, debit cards have replaced your old check book. For the rest of you, debit cards allow you to pay for purchases with money directly from your bank account.
In the old days (like 15 years ago), people would write a check and then track that expenditure in their checkbook so they knew how much money was left in the account (some more seasoned individuals still do this, like my grandma). In a few days, the check would clear and the money would be deducted from your bank account.
Now, you can use your debit card and the money is similarly deducted in a few days, although you’ll likely see a pending transaction notice for your purchases.
The major benefit of a debit card is that money from the purchases you make come directly out of your account. This means that you are using money you already have to make your purchases and you’re far less likely to make unnecessary purchases or spend beyond your means.
While debit cards encourage you to spend within your means because funds are coming from an account with money you already have, there are some drawbacks to consider.
First, debit cards are not a foolproof method to ensure you spend within your means. Most banks/credit unions will clear purchases up to a certain amount even if you don’t have sufficient funds (called overdrafting), leaving a negative balance in your account.
In this case, the bank/credit union will hit you with a hefty $34 fee each time you overdraft, plus you’ll need to pay the negative balance in your account. Most overdraft fees are the result of purchases of $24 or less and are paid within three days. In this case, an overdraft fee of $34 means you’re paying 17,000% interest on a three-day loan.
Another drawback of debit cards is that they provide limited fraud protection. If your card is stolen the thief may be able to drain your account before you or the bank/credit union are aware of it. Furthermore, you may be responsible for up to $500 of fraudulent charges, and even as much as 100% of charges if the transactions were pin-based, if you don’t report the fraud to the institution within two business days.
Finally, debit cards allow you to make transactions with money you already have and thus will not help you build credit.
On the other hand, credit cards allow you to make purchases with money that you may or may not have.
When you apply for a credit card, the lender assesses your credit worthiness and ability to pay back balances, then either approves you for a credit limit (the maximum amount you can borrow) or denies you. You make purchases with your card and then must pay a minimum amount back every month. Any balances you carry will accrue interest.
As a result, with credit cards you’re in debt every day you have a balance. Another way to think about it is that you are racking up small loans throughout the month with each purchase.
For instance, if you bought a cup of coffee for $3 with your credit card that purchase is really a $3 loan. The moment you make the purchase you owe a debt of $3 to the credit card company.
With this mindset, it’s easy to see how people get themselves into major credit card debt without realizing it. When you use borrowed money, it’s easier to make purchases you shouldn’t make because you don’t actually have to pay any of your money right then.
Over time, those small purchases add up and pretty soon you may have a loan balance of several hundred dollars (or more). In many cases, the amount owed exceeds the money you actually have available, leaving you with a balance that then begins to accrue interest.
While debit card institutions will charge you a $34 overdraft fee each time you cannot cover a purchase, credit card companies will begin to charge you interest rates as high as 27% (in some cases even higher). On a balance of $200, 27% interest results in $54 extra dollars you’ll need to pay for the privilege of having a balance.
Read Start Taking an Interest in Interest: Credit Cards for more on how credit card interest is calculated
Even worse, if you continue to make minimum payments on your balance you’ll begin paying interest on previous months’ interest.
Now, having made clear that credit card purchases are a collection of small loans and the danger in using them, there are some major benefits to credit cards you should be aware of.
First, credit cards offer some pretty nice reward opportunities if you’re able to use them responsibly.
There are tons of rewards cards out there offering a variety of different benefits. No matter the reward, the basic idea is that you earn a percentage of points/cash back with each purchase that can then be redeemed. You can also earn sign-up bonuses for spending a certain amount on a card within a certain time period.
Thus, many individuals are able to redeem hundreds and thousands of dollars’ worth of travel benefits, experiences, or cash back for making purchases they were already planning to make.
The caveat with using rewards credit cards for your purchases to earn these rewards is that you MUST pay your credit card balances every month. If you allow yourself to carry balances the interest you’ll pay will wipe out any potential rewards benefits you may earn.
Another major positive to using credit cards is that they carry excellent fraud protection. The Fair Credit Billing Act limits your liability to $50 for fraudulent charges, and some lenders offer $0 liability.
Finally, because credit cards are loans, they help you to build credit. Responsible credit card use allows users to build credit by proving that they can keep their credit usage low (smaller balances) and make their payments on time.
Read What’s in a Credit Score for more information on your credit score.
Which Card is Right for You?
Most American’s have both debit and credit cards.
Anyone with a checking account should have access to a debit card, while the average American has 2.6 credit cards.
Even though most utilize both debit and credit cards, there are some guidelines you should use for which type of card is best for you.
The most important thing to consider when choosing to use debit or credit cards is whether or not you can stick to a budget and pay off your balances. If you’re someone who is prone to making purchases outside your budget and carrying a balance every month, then a debit card that will limit your ability to spend beyond your means is probably best.
On the other hand, if you’re able to pay off your balances every month and spend within your means (even though you know you could spend more), then taking advantage of credit card benefits may be a smart financial decision.
No matter which type of card you use, it will be important for you to track your spending so that you know where you stand at all times. You don’t want to be hit with overdraft fees on your debit card, nor do you want to get into a situation where you can’t pay your credit card balances and be forced to pay interest.
In both cases, you’ll need to ensure that you know where your money is going, how much you have available to pay for expenses, and stay within your limits.
You’re the expert on you. Make sure you assess your habits honestly and make the best financial choice for yourself.
Moral of the Story
There are some pretty stark differences between a debit and a credit card, and each have their pros and cons.
Debit cards have largely replaced checks and allow purchases made to come directly out of your checking account, which encourages you to spend within your means.
Despite this benefit, spending beyond the money in your account will mean an overdraft fee of $34 per purchase. Furthermore, debit cards carry less fraud protection and don’t help you build credit.
On the other hand, credit cards allow you to make purchases on credit, or small loans from the lender. They carry incredible risk for the average person because it’s very easy for those little purchases to add up to spending beyond your means and carrying balances will mean hefty interest charges.
Despite the risk, for those that can pay their balances off every month, credit cards do offer several benefits. First, you can earn thousands in various rewards for purchases you were already planning to make (if you spend within your means). Credit cards also carry excellent fraud protection, and as the name suggests, allow you to build credit if used responsibly.
Only you know what type of card is best for your financial situation. If you can stay within your means, spend unnecessarily, and pay your balances every month then primarily making purchases with a credit card may be okay for you.
If not, a debit card is likely a better solution to help you avoid debt and unnecessary interest.
Remember that every time you use a credit card you are taking out a loan, whereas using a debit card means you’re spending money you already have.
Now it’s time for you to decide which one is right for you.
Talk about Money Saved.