Debit or Credit – Which Card Should I Use?

A Comparison of the Risks and Rewards

Stan Rose, Tax Director
April 2015

Credit cards and debit cards may share similar looks and widespread acceptability, but their similarity ends the moment one is swiped and returned to the owner’s wallet. Many people carry both and have a preference for one over the other, but may not be fully aware of some of the differences. The purpose of this article is not to recommend one over the other, but to make our readers aware of the very different protections, benefits and risks these two alternative methods of payment provide.

Using money you may or may not have

Debit cards are linked directly to your bank account, and their use results in a direct reduction of funds you already have. Credit cards represent a borrowing transaction whereby you agree to pay the charge later. For better or worse, their use can result in spending money you don’t already have.

Fees and mechanics

Debit cards generally involve no fees. When you use one, you authorize the merchant to directly debit (remove cash from) your bank account. Three primary “players” are involved: You, the merchant, and your bank.

By contrast, credit cards involve a number of potential fees, but some of them might be unknown to the user. If each monthly bill is paid in full (as opposed to carrying a balance), late fees and interest charges that potentially apply to a credit card can be avoided. Some cards require payment of an annual fee regardless of use, but many do not. Each credit charge, though, involves a fee that the user may not be aware of and an extra number of “players” compared to a debit card transaction. Remember, each credit card transaction involves a loan. Loans involve interest (or some charge for the use of money) and each of these extra players needs to be paid. Oversimplifying, when you use your credit card, the merchant sells the product to you, and indirectly receives a promise from the bank that issued your card (the issuing bank) that it will pay the merchant. You will later reimburse the bank when you pay your credit card bill. In reality, more players are working behind the scenes, such as an association (like MasterCard or Visa), a processor, and another bank. All these players require fees for their efforts, which reduces the amount reimbursed to the merchant. The portion of fees applicable to the merchant are known as “convenience fees,” and it results in merchants generally receiving slightly less profit from credit card transactions compared to cash transactions. From the customer’s perspective, all of the behind-the-scenes work generally is not seen and is of no concern – you swipe your card, leave with your merchandise, and the merchant absorbs the convenience fee.

Sometimes the merchant passes the charge on to the customer. It is less common than it used to be, but this author recalls stores where different prices were offered for cash transactions, and knows of a rural filling station that as recently as a couple years ago sold gas only for cash. The proprietor explained that margins were so tight that the convenience charge would cause the gas to be sold at a loss.

Another “merchant” that will not absorb the convenience charge is the IRS! Federal taxes can be paid by credit card, but you, not the IRS, will have to pay those fees, which often equal 1 or 2 percent of the charge. For this reason, especially with large amounts, payment of income tax by credit card should be avoided whenever possible.

Rewards

Sometimes a portion of the fees that are shared among the many participants in a credit card arrangement are also shared with the cardholder in the form of “points” such as travel awards, discounts, purchase dollars redeemable at select stores or “cash back” that simply reduces your credit card bill. Debit cards rarely offer any such benefits.

Credit scores

Credit card use, because each transaction technically involves a loan, directly impacts the user’s credit rating. Routine use and full payment of monthly bills will favorably increase your credit score, while carrying a large balance and struggling to make payments will decrease it. Debit cards do not directly impact credit scores. Note that using a credit card is an excellent way for a young person to establish and build a good credit rating. Many students and young professionals gravitate toward debit cards – perhaps to avoid the added step of sending a check each month to pay a credit card bill – but they are missing out on an opportunity to effortlessly build credit that may help them someday when they want to borrow money to acquire a car or a first home.

Customer protection

Federal law prevents credit card holders from losing more than $50 resulting from a fraudulent use of a card, as long as they point out the fraud to the issuing bank in a reasonably timely manner. Even if the charge is not removed, it can still be disputed. The charge represents money someone thinks you owe to them, and you can pay it – or dispute it. (You are in control.) By contrast, a fraudulent debit card charge reduces your bank account balance. Your money is already gone, and it is up to you to convince someone to replenish it. (You are not in control.) Some relatively new laws provide some protection over fraudulent debit card charges, but the protection is significantly weaker than the safeguards related to credit cards. With a debit card, you typically have 48 hours to report a false charge, and after that you are on the hook for as much as $500. If you fail to catch it within 60 days, there is no limit to the loss you must absorb. (Some banks offer stronger protection than this, but they are not required by law to do so.) For this reason, debit card users must be vigilant with their monitoring of activity, or must simply keep account balances low enough that they can live with the risk of its total loss. Credit card laws surrounding disputes over unauthorized transactions are much more customer-friendly than debit card rules.

Conclusion

Undisciplined spenders may be better off with debit cards, because you can’t spend what you don’t have! By contrast, many people have let increasing credit card balances spiral out of control, and interest rates on credit cards are among the highest you will find. But lack of discipline will not treat a debit card user very well either. If he or she is unlikely to check the account activity on a regular basis, it is advisable to maintain a relatively small balance, because the legal protection against fraudulent charges is relatively weak compared to those of a credit card.

Disciplined spenders who pay balances in full will come out ahead by taking advantage of rewards applicable to credit cards, which can add up quickly if cards are used to pay most household expenditures. There is a multitude of card options that can be matched to a user’s lifestyle to maximize those benefits. Those same disciplined users will benefit from stronger credit ratings resulting from prudent use of the cards. In today’s world of fraud and identity theft, credit cards offer an extra layer of defense between you and your money that debit cards simply do not have.

Each type of card has advantages and disadvantages. Hopefully this material helps you make a more informed decision regarding which one is best for you.

If you would like to discuss further, please call your BNN tax advisor or Stan Rose at 1.800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.