Why Consumers Flock to Prepaid Debit Cards

Prepaid debit cards are on fire. These cards -- in which the customer chooses how much money will be available for purchases -- represent the fastest-growing noncash payments in America, according to a Federal Reserve study.

There are three main reasons for this phenomenon, says Rama Malladi, adjunct professor of finance at the College of Business Administration and Public Policy at California State University, Dominguez Hills in Carson, Calif. Malladi outlines what they are and offers tips for discovering whether prepaid debit cards are right for you.

What's the difference between a prepaid debit card and a credit card?

A credit card has a credit limit decided by the card issuer (i.e., a bank). A prepaid debit card is funded by the customer, so the customer chooses how much money to deposit into (a) prepaid debit card. (The) credit card approval process requires a credit check of the customer. (A) prepaid card does not. Credit scores are not necessary to obtain a prepaid debit card.

A typical credit card has (a) late payment fee, (a) prepaid card does not. A typical credit card has (an) interest rate charge on outstanding balances; (a) prepaid card does not. A typical credit card may not have a monthly fee, whereas most prepaid debit cards have a monthly fee.

A credit card can be obtained by filling out a credit application form issued by a bank. A prepaid debit card can be purchased at a store such as Wal-Mart, Target, Vons, etc. A prepaid debit card is a debit card, and more similar to a bank debit card (without a bank account) than a credit card.

Why are consumers flocking to prepaid debit cards right now?

According to the Federal Reserve Payments Study in 2010, prepaid cards are the highest-growth noncash payments in America. Prepaid card transactions grew at a compounded annual rate of 21.5%, whereas credit card transaction(s) grew at a negative 0.2%. Though growing rapidly, prepaid cards represent a small share of noncash payments (5.4% by number of transactions).

There are three main reasons why consumers appear to be flocking to prepaid debit cards.

Aftermath of credit recession: According to the Federal Reserve Flow of Funds report, the credit growth in America has declined from 9.6% in 2006 during the height of the credit boom to negative 2.2% in 2010 and has remained low ever since. This is mainly because of a general consumer aversion to credit, lack of credit available due to stringent lending standards and lower demand due to (a) decline in the number of credit-eligible borrowers.

Higher fee to maintain a bank account: According to the October 2011 report "Still Risky: Bank Fees and Disclosures in the States" by The Pew Charitable Trusts, a nonprofit policy research group in Washington, D.C., 89% of the checking accounts offered at the 12 largest U.S. institutions involve bank fees. Due to limited opportunities to make a profit as a result of (a) low-interest rate environment and tighter consumer regulations, banks are trying to be as innovative as they can to raise revenue. As a result, consumers are trying to avoid bank accounts altogether. Prepaid debit cards allow a consumer to avoid both the credit card-related fee as well as (the) bank-related fee.
Ease of use and general availability: Prepaid cards can be purchased in any retail store. Popular prepaid cards can be purchased in Wal-Mart, Target, Albertsons and any of the 60,000-plus locations in America. In addition, these cards can be reloaded easily in these stores (without going to a bank) or online.

How are consumers using prepaid debit cards -- as a replacement for a checking account or for some other purpose?

Based on the profiles of 160 million American households, the answer to this question depends on customer segmentation. According to (the) 2010 annual report of Green Dot, one of the largest prepaid card issuers, the usage of prepaid cards depends on the following four customer segments.

Never-banked consumers: Households in which no one has ever had a bank account. (They) use prepaid cards as a safe, controlled way to spend cash and as a means to access channels of trade, such as online purchases.
Previously banked: Households in which at least one member has previously had a bank account. (They) use prepaid cards as a convenient and affordable substitute for a traditional checking account by depositing payroll checks, pay(ing) bills, shop(ping) online, monitor(ing) spending and withdraw(ing) cash from ATM machines.
Underbanked: Households in which at least one member currently has a bank account but that also use nonbank financial service providers to conduct routine transactions like check cashing or bill payment. (They) use prepaid cards in ways similar to those of the never- and previously banked segments, but additionally as a credit card substitute.
Fully banked: Households that primarily rely on traditional financial services. (They) use prepaid cards as companion products.

Are prepaid debit cards a viable alternative to checking accounts?

Yes. The answer mainly depends on the monthly fee that a customer is paying in a traditional banking relationship versus how much the customer expects to pay using a prepaid debit card.

American Express has launched a new prepaid debit card that has no annual fee, no monthly fee, no customer service fee and no transaction fee. It is possible to direct deposit wages into a prepaid account.

What are the dangers of prepaid debit cards for consumers?

Consumers have to closely look at all the fee details. Though major prepaid debit card holders are transparent and publish this information, it is always a good idea to check the (Better Business Bureau) reports.

After initially purchasing (a) prepaid card at a retail store, the consumer has to activate the card by calling a phone number. If there are any issues in activation, the money can be stuck and unusable for a while.

Are there any advantages to prepaid cards over checking accounts?

Yes. The answer mainly depends on the monthly fee that a customer is paying in a traditional bank, and the network that the local bank provides. If a customer is banking at a large bank with a nationwide network and has a large deposit with the bank and pays no monthly fee, then the customer may be better off with the bank's checking account.

Conversely, if a customer is banking at a small bank with a small network of ATMs and high ATM fees or pays various monthly fees, then the customer may be better off with the prepaid card.

We would like to thank Rama Malladi, adjunct professor of finance at the College of Business Administration and Public Policy at California State University, Dominguez Hills in Carson, Calif., for his insights. We would like to thank Steve Pounds, senior editor at Bankrate.com, for providing the questions.