What It Means
A debit card is a plastic electronic-payment card that draws funds for purchases directly from the cardholder’s bank account (to debit means to withdraw or spend). It can also be used to withdraw cash from a checking account at ATMs (automated teller machines). Debit cards are issued by banks to their account holders. When used to make purchases, the debit card is a convenient and secure alternative to cash that works like an electronic, or “paperless,” check. Indeed, because debit cards usually draw funds from checking accounts, they are often referred to as “check cards.”
And yet, in its physical appearance and technology, a debit card is more like a credit card than a check. Like credit cards, debit cards bear the logo of a major credit card company (especially MasterCard and Visa), and on the back they have a magnetic stripe that contains the information needed to process a transaction. At the time of purchase (commonly known as the point of sale, or POS), the merchant swipes the debit card through a card-reader machine. In order to complete the transaction the customer must either enter a PIN (personal identification number) or sign for the purchase (as is done with a credit card). The details of the purchase are processed electronically through a central computer network run by MasterCard, Visa, or whichever credit card company is affiliated with the card, and then transmitted to the cardholder’s bank, where funds are withdrawn.
The source of the funds is the major difference between debit cards and credit cards. With a credit card, the cardholder makes purchases on a line of credit, a maximum purchasing amount that is based on the cardholder’s potential to pay, rather than the amount of money he or she has available in the bank. In other words, the credit card user is allowed to “pay later”; the bank that issued the card pays for the purchase and expects the cardholder to repay the bank in the future. With a debit card, on the other hand, the cardholder is required to “pay now,” meaning that she can only make purchases up to the amount of funds that she has in the bank. If she tries to make a purchase that exceeds the amount of these funds, the card will be declined. Although the withdrawal of funds appears to happen immediately, there is in fact a lag time during which the transaction is complete but the funds have not yet left the cardholder’s account.
When Did It Begin
Introduced in the early 1980s, the first debit cards were called “ATM cards” because their sole function was to enable bank customers to withdraw cash from their bank accounts using ATMs. The original ATM cards could not be used to make retail purchases.
By the mid-1980s many merchants had begun to use computerized point-of-sale (POS) systems, which enabled customers to swipe their ATM cards at cash registers, enter a PIN, and pay for their purchases through an electronic transfer of funds from their bank account to the merchant. POS systems were primarily available at grocery stores, gas stations, and other businesses that processed a high volume of customers making relatively inexpensive purchases.
The watershed moment for debit cards came in the early 1990s, when the cards were enhanced with the Visa or MasterCard logos, meaning that they could be used to make purchases anywhere that Visa or MasterCard credit cards were accepted. This innovation vastly expanded the use of debit cards.
More Detailed Information
When a debit card is swiped through a reader at the time of a purchase, the merchant asks the cardholder, “Debit or credit?” If the customer chooses “debit,” it will be an online transaction. He or she must enter a PIN for electronic authorization. Once the card is verified, the PIN is authorized, and the system has confirmed that there are sufficient funds in the customer’s account, the purchase is complete. No signature from the customer is needed. Usually the bank puts an immediate hold on the funds to cover the purchase (meaning that the amount of the purchase is subtracted from what is called the “available funds” in the account), and the transaction is cleared through a regional network at the end of the day.
If the customer chooses “credit,” it will be an off-line transaction. The card is still swiped through a reader, but no PIN is required. Instead, when the system has verified the card and confirmed that there are sufficient funds in the customer’s account, the customer signs a receipt (as he or she would if using a credit card), and the purchase is complete. With off-line transactions, however, the process of clearing the transactions happens in stages: although the bank may place an immediate hold on the funds to cover the transaction, the funds may not actually leave the cardholder’s account for a couple of days.
As with credit cards, merchants who accept debit cards pay a per-transaction processing fee known as an “interchange fee” for the convenience of using the card system. Typically an online transaction carries a set fee of 7.5 to 10 cents, whereas the fee for an off-line is calculated as a percentage (usually about 2 percent) of the total sale. The bulk of the fee goes to the bank that issued the card, and a fraction of the fee is given to the credit card company. Thus, the merchant prefers customers to choose online PIN transactions, while the bank prefers them to choose off-line signature transactions.
For consumers the most significant drawback of a debit card arises in the unfortunate event that the card is lost or stolen. Debit cards carry a greater liability risk than credit cards, meaning that if the card falls into the wrong hands and that person begins making unauthorized purchases, the cardholder may be held responsible for the transactions. With a credit card the cardholder is not liable for more than $50 of fraudulent card use. But with a debit card, if the cardholder waits more than two business days to notify the bank about the missing card, he or she may be liable for up to $500 of fraudulent spending.
There are other ways that a missing debit card can be more problematic than a missing credit card. With a credit card, the only issue to resolve with the credit card company is whether or not the cardholder owes money for fraudulent purchases. In contrast, the holder of a lost or stolen debit card must persuade the bank to restore illegally spend funds to his or her bank account. Further, if the bank account has been depleted, the cardholder may face an overdraft situation (in which he or she does not have sufficient funds to cover checks, automatic payments, and other withdrawals from the account).
In the mid-1990s the use of debit cards began growing at an exponential rate. In 2003 the number of electronic-payment transactions (debit cards and credit cards together) surpassed the number of paper check transactions in the United States for the first time. With an estimated annual growth rate of 23.5 percent (twice the growth rate of credit card usage), debit cards were the fastest-growing type of electronic payment, and it was projected that debit card transactions would surpass both paper check transactions and credit card transactions within a few years.
With growing awareness about the overwhelming burden of consumer debt and high interest payments (in 2005 the average U.S. household carried $9,200 in credit card debt), many Americans began to favor their debit cards over their credit cards as a way of improving their personal financial discipline. Some consumers prefer to use their debit cards knowing that they have a built-in spending cap based on the amount of funds available in their accounts. Some use their debit card instead of cash to facilitate money management; the fact that all transactions are printed on the cardholder’s bank statement can make it easier to keep track of purchases.
Debit card issuers also sought to increase their competitive edge against credit cards by introducing the same kinds of rewards programs that credit cards had been offering their cardholders for years, such as points toward air travel, sweepstakes entries, and cash rebates (or refunds).