Debit cards and credit cards have quickly become the de facto way many of us make financial transactions. Paying bills online, paying for gas at the pump, buying a burger at a restaurant, and purchasing groceries are all examples of interactions where we might use these cards. However, just because we use them every day does not mean we really understand them. In fact, I meet many individuals who are just starting to take on their own financial responsibilities that simply do not know the difference between the two. Not knowing what a debit or credit card does can leave you in quite a financial bind. Here I will cover some of the key differences between the two types of cards to help you make an informed decision on which one you want to use.
1. Debit cards do not build credit
One of the first misconceptions that many have between credit and debit cards is that debit cards will build credit. Debit cards do not build credit directly. They can be used to pay things like loans that are in your name – such as a mortgage – which can help build your credit. But on their own, they will not build credit.
Credit cards on the other hand help build your credit by simply using them and paying them off, in full, each month. How is this different from a debit card? Simple, a credit card is not linked to an account, so when you use it, you create a credit for yourself. When you pay it off, it builds your credit score. Though, credit cards are also a double-edged sword. If you run them up too high or do not pay them off, you can really hurt your credit score and credit.
2. Debit cards are directly linked to one of your financial accounts
Another difference between credit cards and debit cards is debit cards are directly linked to one of your financial accounts – typically a checking account. This means when you use a debit card, money is pulled directly from your account. While this means there are no bills, it also means you have to be careful how much is in your account. If you use your debit card and do not have the funds, then you will either get denied or have to pay an overdraft fee.
Because a debit card is linked to your financial account, you need to be extra vigilant. If your card becomes compromised, then the criminal will have direct access to your bank funds. You can close a card and file a dispute, but you still might be out of the money stolen until the dispute is resolved. Some banks do offer provisional credit, which can ease this unfortunate circumstance.
3. Credit cards are a credit line – not free money
Another misrepresentation that some have of credit cards is that credit cards are “free” money. This could not be further from the truth. Credit cards offer you a credit line. You can use the credit line to pay or buy whatever you want, with the expectation that you will pay it back. If you max out your credit card and do not have the money to pay, credit companies will still expect their money and they will do whatever they can to retrieve it from you. There are ways to navigate a situation like this, but in most cases, it will wreck your credit. My suggestion is to never find yourself in this position by only spending what you can cover (aka pay off your whole credit card balance every month). If you are in this situation, it is best to seek professional financial advice.
4. Debit cards typically do not have rewards programs
Since debit cards act as a direct withdraw from your account and are supplied by a financial institute – like a bank – they typically do not offer rewards like “cash back” when you use them. Some companies like Paypal may have a debit card that does give cash back on purchases, but this is generally not the case. If you are looking for rewards on purchases such as cash back and points, then you will find more success looking at credit cards.
Most credit cards today carry some sort of rewards program. A “percentage back” or points earned on each purchase are currently normal. There are also some cards – those supplied by department stores – that will offer you discounts if you shop at their store or website and use their card. Other cards from places like an auto mechanic shop may give you 0.0% interest over six months on repair jobs.
5. Credit cards have high interest rates
The last distinction I will make today is that while credit cards do not have overdraft fees, they make their money by typically having extremely high interest rates. I have seen rates north of 20% on some cards. To put that into perspective, according to Freddie Mac you could get a mortgage at about 4% with good credit in 2018. With car loans and home equity lines of credit hovering around the same percentage, it is easy to see how high credit card interest rates are by comparison. Even a small amount of credit card debt at $1,000 with a “generous” 15% APR interest rate will take you close to six years to pay off if you are only paying the minimum.
The good news is, most cards offer a “grace” period – typically a month – where if you pay off the card within that grace period you will not have to pay the interest. My suggestion, pay off your whole credit card balance every month. As an added bonus – as stated above – this will also help build your credit.
To sum up the differences, debit cards are directly linked to your account, and therefore when used, draw money from your account. This will not build credit and typically will not give you rewards, but it has the benefit of helping you use only the money you have, and you will not have to deal with interest rates. Credit cards on the other hand give you access to a line of credit – where you do not spend your own money but has an expectation that you will pay it back. As such, these cards typically have rewards and will help you build credit, but come with steep interest rates if not paid off fully each month.
Please note: I am not a certified financial planner (CFP), however, my comments are made based on personal investigation and experience.
Quote of the day: Rather go to bed with out dinner than to rise in debt. – Benjamin Franklin
