Debit or Credit?

Who Pays Interchange Fees?

Business owner paying bills at laptop in cafe
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When you make a purchase with your debit card, you’re often asked if you’d like to make it a debit or credit transaction. What’s the difference? The choice you make determines how your purchase is processed, who pays the bill for that processing, how long it takes, and what your rights are. This page covers how interchange fees work and just how important your choice is.

Is it Debit or Credit?

When you use a debit card, you can sometimes choose how the purchase is processed.

It can either be an online transaction or an offline transaction. If you punch in your personal identification number (PIN), it’s an online transaction – it gets completed electronically and it’s done pretty quickly. If you don’t use your PIN and you sign a charge slip instead, it’s an offline transaction. Offline transactions are processed much like plain-vanilla credit card purchases.

Even if you use a debit card, offline transactions are very much like credit card transactions. Your debit card might have a Visa logo on it, for example, so it runs through the Visa network. It’s not a credit transaction, but it uses the same infrastructure.

In summary, when you’re using a debit card:

  • Choosing “Credit” makes it an offline transaction
  • Choosing “Debit” makes it an online transaction

Who Cares?

So far, you may be unimpressed. Who cares how each transaction is processed? You might not, but banks and retailers do.

When you do an offline transaction and simply sign a charge slip, the retailer has to pay a small percentage of your total purchase – perhaps 2%. This fee goes to the bank that issued your debit (or credit) card as an interchange fee.

What about online transactions? Retailers can get those done for a lot less.

They might only pay 10 cents or so per transaction.

As you might imagine, 2% of every purchase adds up to a lot of money. The banks and credit card companies would love for you to choose credit because they get 2% of every dollar you spend. Retailers, on the other hand, beg to differ. They’d prefer that you choose debit so that they don’t have to pay a hefty interchange fee (but in some states they can add credit card surcharges that pass that fee back to you).

In order to maximize revenue, banks give you an incentive to choose credit (or a penalty for choosing debit, depending on how you look at it). In the past, they have charged fees for online transactions – usually in the ballpark of one to two dollars. Once you discover these fees, you’re more likely to choose credit next time. In addition, they may offer rewards (such as the opportunity for a better interest rate, airline miles, or entry into a sweepstakes) when you choose credit.

Of course, somebody has to pay the 2% interchange fee. Some retailers try to pass it on to you directly, while others absorb it as a cost of doing business. However, it has to come from somewhere – they have to build it into the price of the products and services you buy.

Choosing to buy in a debit or credit transaction also affects your bank account.

If you’ve ever paid for gas at the pump, you know that you swipe your card before pumping gas. The machine doesn’t know how much gas you are going to buy. As a result, it has to take a wild guess. It checks to see if you have at least $50 or $100 available in your account – in other words it authorizes a purchase. If authorization comes back, the retailer “blocks off” that $50 or $100 so you can’t spend it elsewhere.

You might only by $10 worth of gas. Nevertheless, $100 will be blocked off for several days. In a worst case scenario, you’ll end up bouncing checks even though you have the money – it’s just “not available”. This means that if you use your debit card for everyday purchases, you need to be careful. Two ways to protect yourself are:

  • Keep extra cash in your checking account
  • Use your PIN if you don’t have extra cash in your checking account

Note that using your PIN will make the transaction clear your account more quickly. However, there is a security issue. By entering your PIN number, you run the risk that somebody else will discover it. Thieves (or a hidden camera) may see which numbers you hit on the keypad, or the retailer’s device could give up your PIN – whether on purpose or by accident.

If your PIN is compromised, scammers have direct access to your checking account. This is pretty scary!

They can spend that money, or they may even create a fake ATM card to make withdrawals. If they drain your checking account, you won’t be able to pay important bills. Your account may be protected from fraud, but you’ll have to go through some harrowing days or weeks without any money while the issue is resolved.

Your Rights With a Debit Card

You are protected if your debit card is used by a thief. However, you have to act fast. Compared to credit cards, debit cards carry a lot of risk. With credit cards, you’re limited to $50 of liability for fraudulent use. What’s more, the thief spent the bank’s money – he didn’t empty your checking account and cause you to bounce important checks (or rack up fees for overdraft protection).

With a debit card, you are protected as follows (source: Federal Reserve and Federal Trade Commission):

Your loss is limited to $50 if you notify the financial institution within two business days after learning of loss or theft of your card or code.

But you could lose as much as $500 if you do not tell the card issuer within two business days after learning of loss or theft.

If you do not report an unauthorized transfer that appears on your statement within 60 days after the statement is mailed to you, you risk unlimited loss on transfers made after the 60-day period. That means you could lose all the money in your account plus your maximum overdraft line of credit, if any.

Given the added risk of loss, plus the headaches of risking direct access to your checking account, I don’t think it’s worth it to use a debit card for purchases.

Nevertheless, there may be times when it makes sense – if you can’t qualify for a credit card or if you want to help a youngster develop good habits.

The Price of Choosing Credit

Again, choosing credit drives up costs for retailers. They have to pay an extra 2% on everything they sell (plus taxes). Because money doesn’t grow on trees, they have to pass this cost along somehow. They do it by charging higher prices on everything, or by earning less in profits. If everybody chose debit, goods and services would likely be less expensive. However, the banks currently have the most power to influence our decisions.

In their defense, they have the right to try and recoup costs – plus, you can always choose debit, pay a small fee, and feel good about it.

Those fees are also a big part of "rewards" programs. When you pay with plastic, you might get points, cash back, or discounts with certain retailers that have a relationship with your bank. Rewards are best with credit cards, because retailer fees are higher. Debit card rewards are still available, but they aren't nearly as rich as credit card rewards because the banks have to pay more (instead of having retailers pitch in).