Tuesday, April 20, 2010

Debit Card vs. Credit Card

Which do you use? Debit card or Credit card? I have always preferred using a Credit card for several reasons but before I discuss them let's explain a bit more about these two types of non-cash payment.

A Debit card is directly linked to a bank checking account. When you use a debit card it is just like using an ATM card with the merchant you are paying; the money comes out of your bank account immediately. If you do not have enough money available you will be charged a fee for over-drafting your account.

A Credit card provides you with what is called a line of credit. The credit card company gives you an amount of credit (e.g. $5,000) and charges interest for any amount you do not pay off in the time specified (i.e. when the bill is due). When you use it no money comes out of your bank account but you have "borrowed" money from the credit card company which you must repay. Normally, you have approximately 30 days to repay this "loan" and if you do not you are charged interest. BUT, if you pay off the balance each month, you are able to manage your cash while still obtaining what you want sooner. In other words, if you will have enough money to buy "this thing you want" next week, you would use you credit card, buy the item now, leave your cash in the bank to earn interest and pay off the credit card balance at the end of the month.

The danger of the debit card is the money comes out of your account immediately. The danger of the credit card, if you are not disciplined, is you may charge more than you can really afford.

There are also differences in the fraud protection for each type of card as described here.
As the site points out there is better fraud protection with a credit card. While the debit card is "similar" to the credit card liability, notice you have to notify the bank much more swiftly if you discover fraud which means you must constantly be on top of your account (only two business days with the debit card to only incur a $50 charge while you have up to 30 days with the credit card). Depending upon how quickly you act, you might be liable for up to $500 with a debit card. While you should always be aware of what is happening with your account, you may not be able to do this swiftly enough to avoid problems.

The other risk with the debit card is that if there is a large amount of money taken out of your account...it's gone and it could take you weeks to get it back.  That means you have no cash - none at all!  You would then have to rely on your credit card for everything and possibly go more into debt.  Also, if you have checks that have not cleared or auto-draft (ACH) payments
that have not occurred for things like your house payment, car payment or utility bill, you could become over drawn and create another whole set of problems with fees from the bank and from merchants or service providers due to insufficient funds.

One unique advantage of a credit card is you AUTOMATICALLY get at least 30 days to "pay" for the charge whereas, as mentioned previously, the debit card removes the funds immediately. If you "time" your purchase so it is near you bill closing date, you could have almost 60 days (two billing cycles) to pay for the charge. Doing this allows you to manage your budget and your cash especially for large purchases.

Using a credit card also helps you build a credit history. Paying the balance off each month on time improves your credit score which reduces the interest rates you are charged on loans for a car or house. Using a debit card does not help you build this credit history.

Finally, you may have an "emergency" large expense (e.g. car repair) that might exceed what your budget would allow for this particular month. Using the credit card even though you can not pay off the entire balance allows you to pay for the "emergency" and then factor new costs into your budget so you can pay off the balance as soon as possible without having a major change to your overall finances as would happen if all the money came out of your account immediately with a debit card.

For these reasons, I advocate using a credit card and paying off the balance every month. That is what works best for me and to stay out of trouble you must be disciplined and use the credit card wisely. But the ultimate decision is yours. Do your homework and understand how these different tools work and their benefits and drawbacks. YOU must always make the choice that is best for YOUR circumstances and YOUR financial plan.

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