Debit Cards are Bad for You

Photo by Andres Rueda

Overdrafts are a Pain

I recently read an article by the New York Times, titled The Card Game - Overspending on Debit Cards Is a Boon for Banks. This article underscores my antagonism against debit cards, in contrast primarily to credit cards. I have never owned a debit card, and despite my bank's efforts to get me to convert my ATM card to a debit card, I've always preferred my credit card as my primary form of payment for goods and services. My argument is that you should only have a debit card if you're unable to get a credit card, or if you can't get a credit card with a limit high enough to support your typical spending habits ... but you can work toward that and toss the debit card once you get a limit that's high enough.

I have two credit cards only because my first one was not usable during my trip to Europe in 2007, but most of my daily purchases still go to my first credit card. I pay off both credit cards at the end of every month and make a comfortable bonus in cash-back rewards. Similarly, many people use debit cards for daily purchases and rely on their paycheck[*] to fund their checking account through direct deposit each month. In theory, the diligent customer will experience the same benefits from both cards. However, everyone has the occasional lapse in judgment or memory, and the protections provided the two card types vary greatly.

Conventional Wisdom

The primary argument I've heard for debit cards is that they force you to spend only what you can afford, since you can't spend money you don't have (if you disable overdraft protection). Credit cards, as the argument goes, encourage willy-nilly spending and happily let you borrow money that you can't yet pay back. If, however, you're a responsible individual, credit cards have the advantage because there's a psychological difference in how the two card types help you control your spending each month. A debit card could be interpreted as a credit card that is immediately paid off each time you use it.

Similarly, if you pay off your credit card each month then it's like having a bank account that automatically has a fixed amount at the start of each month. There's a big difference here, though: that fixed amount is your credit limit, which is probably a good bit more than your monthly income. As a result, credit cards encourage you to maintain a healthy buffer between the amount you can afford to spend and the amount you're allowed to spend. If you accidentally overspend your income one month, credit cards give you a one-month buffer to correct the problem (either by lowering spending the next month, paying a penalty in the form of interest, or borrowing money from savings), whereas debit cards penalize you immediately and with much greater severity.

Some Scenarios of Interest

There are other benefits to credit cards. Here are some scenarios to describe some differences between the two types of cards:

Scenario 1: You accidentally spend more in one month than you can afford to pay that month.

• Credit card: You are charged interest (upwards of 35%, possibly) on the total amount overspent until you pay it off, assuming you stay under your credit limit. Alternatively you can pull a bit out of savings and loan yourself the money. In any case, you'll have roughly a month to decide how to pay for the excess with no interest penalty.
• Debit card: You are charged one overdraft fee (upwards of $35, possibly) per transaction, with the largest transactions applied first to cause the maximum number of overdrafts. Even if you have money in savings that could cover the transactions, the overdraft fees have already been charged. If you have overdraft protection disabled then you simply can't spend the money, which could be serious depending on the situation.

Scenario 2: Bad guys steal your card number and spend a bunch on it.

• Credit card: You notify the CC bank and they delete the fraudulent charges a week later[*] and refund you any interest charged on those purchases during that period. When the bill comes due you pay the correct bill amount.
• Debit card: You notify your bank and they credit your account a week later, but in the meantime you have no money to spend. Your debit card might still work (racking up overdrafts that will hopefully get refunded), but you can't use an ATM, your paper checks may bounce, and online bill pay will probably not work.

Scenario 3: You're close to your income limit and you buy a bit of expensive gasoline downtown to get you home for the evening, then plan to fill up when you get home.

• Credit card: Your card is charged the exact amount used by both pumps.
• Debit card: In order to approve your debit card to activate the pump, your bank account has a $100 "hold" placed on it to cover whatever amount of gas you buy, even though you only dispense $5 worth. Since you only had $120 in your account, you can't buy gas at home because your debit card says you don't have another $100 to spend. The hold may not clear until tomorrow—it's up to the retailer.

Scenario 4: You're ready to buy a house and you're applying for a mortgage.

• Credit card: You've been paying off your bills on time, and maybe you kept an occasional balance, but you have a good credit history and score, so you get a good mortgage rate.
• Debit card: You use your card all the time and have never overdrafted, but none of this history is reported to the credit agencies and you basically have no credit score. It's a real pain to get a mortgage of any sort.

The Lesson

Get a credit card and work toward getting the highest limit possible, even if it's way over what you need. Routinely ask for limit increases as long as the company will give them to you. This helps your credit score (by lowering your total debt utilization) and it helps you maintain an "oops" buffer. Oh, and you'll usually get rewards! Once you have enough to cover any large purchases, toss the debit card and have it replaced by a standard ATM card. Just make sure to pay off your credit card bill each month, and don't think of that credit limit as any indicator of how much you should be spending each month—it has nothing to do with that!