Credit cards and debit cards may look similar, but it’s important to understand the differences between the two — and the impact those differences can have on your personal finances.
What’s the difference between a credit card and a debit card?
While both credit cards and debit cards allow you to pay for goods or services with a convenient swipe or tap, the primary difference between the two is where that money is coming from.
Debit cards function by instantaneously withdrawing money from a bank account in which you have previously deposited funds. This means your spending is limited by the amount of money you have available in that account.
Credit cards allow you to make your purchase on a line of credit. This is essentially a digital I.O.U. — the card issuer tracks your spending, and it’s your responsibility to pay this money back at the end of the month. With a credit card, the amount you can spend is only restricted by your card issuer’s credit limit.
What are the pros and cons of using a debit card?
- It’s safer than carrying cash. Need access to your money? You can swipe a debit card at checkout, withdraw your money from an ATM, or request extra cashback on a purchase. In all three cases, you’ll either be asked for your 4-digit pin code or signature, which is certainly more secure than carrying a wad of $20 bills in your pocket.
- You’ll accumulate interest on your money. As opposed to keeping your money hidden in a secret box under your floorboards, stashing your money in a bank actually earns you more money. Like any bank account, a checking account linked to your debit card will usually net you a small amount of interest per month.
- You won’t spend more than you have. This is the ultimate pro/con of credit vs. debit cards. Debit cards encourage responsible spending — you won’t overextend yourself and find yourself in debt.
- You can’t spend more than you have. Yep — it’s the double-edged sword of debit cards. Because if your bank account is empty, your bank account is empty. Nothing much to do until the next payday. And this can bite you if there’s an emergency.
- You may owe fees. If you lose track of your spending and try to buy a $12 hamburger when there’s only $8 left in your checking account, it may go through — but you’ll owe the bank overdraft fees. If you withdraw money at an ATM not owned by or associated with your bank, you may also owe a foreign ATM fee (typically between $2-$4).
- You have fewer fraud protections. It’s everyone’s worst nightmare…your wallet gets stolen, and before you notice, the thief goes on a spending spree. How do you get that money back? Or perhaps you purchase something online, but the package gets stolen from your front doorstep. In both cases, credit card purchases are more robustly protected by the federal government than debit card purchases. You are protected by the Electronic Funds Transfer Act (EFTA), but your liability skyrockets if you don’t report your loss within 48 hours.
What are the pros and cons of using a credit card?
- Credit cards are crucial in emergencies. It can happen to anyone. Your car gets rear-ended, your furnace breaks, or you’re behind on your bills for the month. In any situation where you need to borrow money to cover an emergency expense, credit cards can be a lifesaver.
- Credit cards help build your credit score. Your credit score is that pesky three-digit number that lenders use to determine how likely you are to repay loans. But it’s not just about qualifying for car loans and home mortgages — a good credit score can earn you lower interest rates, saving you thousands of dollars over the lifetime of a loan. A credit card can improve your credit score when you keep your borrowing percentage low and pay your bills on time.
- Credit cards protect the consumer. Because you’re not spending your money, any fraudulent activity on a credit card is less about getting your own money back, and more about simply reporting the fraudulent activity so the bank can deal with it. Phew! In most cases, the Fair Credit Billing Act (FCBA) says your maximum liability for purchases on a missing or stolen card is only $50, as long as it’s reported in a timely manner.
- Credit cards offer exciting rewards. Because credit cards are big business, credit card companies like to entice customers with various incentive programs. These may involve cash back percentages, accumulated points, airline miles, planting trees — you name it. Carefully investigate which rewards programs seem most valuable, appealing, and aligned with your values.
- Credit cards may charge fees. Depending on which credit card you’re using, you may be charged an annual or monthly fee.
- Credit cards can encourage a risky cycle of debt. If you charge more to your credit card than you’re able to pay off by the end of the month — no worries. You can pay the minimum fee and wait until next month when you’re flush…right? In theory, this is true. But whenever you don’t pay off the entire bill, you’ll be charged a percentage for interest by the credit card company. This can be anywhere between 13% and 25%, so it’s best practice to pay off as much as you can each month.
- Credit cards may damage your credit history. Just as responsible credit card usage can improve your credit score, irresponsible spending and out-of-control debt will have exactly the opposite effect.
Should I use a credit card or a debit card?
Short answer: it depends!
Debit cards are useful for the frugal spender who wants to ensure they’re living within their means. But the benefits of credit cards are too numerous to overlook.
Most smart spenders will have a debit card and at least one credit card. Play the system right, and a credit card can net you cashback, rewards, and a consistent boost to your credit score.