(Updated February 2015)
Badly burned by a historic financial meltdown, consumers are increasingly mindful of their financial options. Understanding tools like credit cards and debit cards is smart money management. It can keep you out of debt and actually save you money.
In the years prior to the crash, consumer debt reached unprecedented levels, producing a situation so dire that consumers are finally embarked on a crash course in financial literacy. One financial topic that's worth learning is the difference between credit card and debit cards. Taking a close look at these two options is a good step toward getting a handle on your consumer debt.
Tight budget? Choose the debit card
The key difference between the debit and credit card is speed. With a debit card, any purchase made is instantly deducted from your savings or checking account. With a credit card, you won't have to make a payment for 15 to 30 days after purchase, and even then, you don't have to pay the entire balance.
The debit card is simply a plastic substitute for cash or check. It only provides funds if you carry a large enough balance in your account. If you don't, the card won't work. There are some banks that allow you to exceed your balance and draw from an overdraft account, but you'll pay interest on any funds you tap.
As far as making purchases go, a debit card displaying the Visa, Mastercard, Discover or American Express logos can be used to make purchases on any network that accepts those credit cards. You can even use them for online or telephone purchases by providing the card number and the 3-digit card verification value (CCV) from the back of the card.
On the downside, with a debit card you won't have access to the rewards programs and the security benefits offered by credit cards.
Debit card or ATM card?
A debit card is similar to but more versatile than its close cousin, the ATM card. Like an ATM card, you can use it to make cash withdrawals and deposits at automatic teller machines. You may also find it easier to avoid paying fees for going outside your network on such transactions because the networks of the credit card companies tend to be more extensive than those of individual banks.
On the other hand, a debt card doesn't require a PIN number to make purchases - that's only needed for making deposits and withdrawals - so it's easier to abuse if lost or stolen. With an ATM card, the 4-digit pin is required for every use. Debit cards also don't offer the same legal protections against fraudulent use that credit cards do, although some banks will offer enhanced protections as a matter of policy. ATM cards offer few such protections, aside from their PIN.
Debit and ATM cards can be helpful for someone prone to compulsive shopping. If you've had consumer debt problems in the past, it can help you keep your spending in check. At the same time, it's still easy to quickly drain your account and bust your budget each month with spur-of-the-moment transactions.
Benefits (and pitfalls) of credit cards
Credit cards offer a bevy of attractive benefits in comparison to debit cards. Most credit card companies offer rewards programs, which offer you points for every purchase you make. Points can eventually be redeemed for airline tickets, gifts, or even cash. You can tailor the rewards programs to your personal tastes.
Cash-back rewards are increasingly being offered by some credit cards in lieu of a points-based reward. You simply get a credited back to your account a certain percentage of your purchases - often a flat 1 percent across the board, or 5 percent back for purchases in specific categories, such as gasoline, dining out, home improvement stores and the like. These extra cash-back categories may change every few months, or you may be able to get a card that always gives 5 percent back on certain categories and 1 percent back on everything else.
Many credit cards charge annual fees, although if you have decent credit you shouldn't have any problem getting a no-fee card as long as you have decent credit. Typically, the annual fee cards offer enhanced reward programs, such as additional frequent flyer miles, compared to the no-fee cards. You'll have to decide which makes the most sense for you.
Using a credit card wisely
When you use a credit card, you also have the luxury of being able to delay the payment on an item. This gives you added flexibility when you're making purchases; you only need to pay the card's minimum balance, so it can effectively act as a short-term loan. Unfortunately, credit card interest rates tend to be quite high - often in the mid-teens - so it can be a very expensive way to borrow money.
The smartest option is to carry a credit card but treat it like a debit card: Pay off all your balances in full every month. That not only prevents your debt from piling up ever-higher month after month, you also pay no interest charges as long as your balance is paid in full each month. So it's like a free short-term loan.
It's the smart way to have your cake and eat it, too, as you'll have the flexibility of a credit card, but still be able to cash in on the rewards. The benefits of a credit card are lost, however, if you fail to make those minimum payments. Picking the right option is meaningless if you don't have the discipline to make it work.