Lifestyle - Steady Ascent of the Debit Card

Christopher Palmeri

Raquel Garcia is serious about avoiding debt. The 18-year-old customer-service representative for U-Haul (UHAL) recently canceled her credit card. Now she gets her entire paycheck deposited onto a prepaid debit card, which she uses for all her purchases. Since she can access only what's in the account, Garcia no longer worries about breaking her budget: "I'm spending just what I need."

For consumers reeling from a series of economic body blows, debit cards are increasingly becoming the plastic of choice. Some use the cards, which pull money directly from a bank or other account, as a budgeting tool to limit spending. Others are embracing them out of necessity as banks clamp down on credit. All told, debit purchases are expected to climb 13% in 2008, to $1.2 trillion, according to The Nilson Report, an industry newsletter—compared with a 3% rise, to $1.9 trillion, for credit-card transactions. At Visa (V), the No. 1 card company, debit spending could surpass credit this year.

For the banks issuing the debit cards, the trend seems bittersweet. On the plus side, debit cards don't pose a threat to the banks' books like credit-card accounts; losses are mounting as borrowers fall behind on their payments. But the profits on debit cards aren't as plump since banks don't collect interest on them. Issuers largely make money from fees, which pale next to those on credit cards. Retailers, for instance, fork over 1.6% of credit purchases to banks, three times the amount on debit transactions.

But don't shed a tear for the banks just yet. Time and again they've shown an uncanny ability to adapt to a new profit landscape, and the debit-card business appears no different. Consider the evolution of overdraft fees. It used to be that banks denied debit purchases when consumers didn't have enough money in their accounts. Now 14 of the 15 largest banks approve transactions but hit customers with a fee if they exceed the funds. It's not unlike getting charged for bouncing a check. A recent study by Web site Bankrate.com (RATE) found that overdraft fees now approach $29, up 3% in the past year.

Those penalties are easier to trigger, too. In the past customers had up to a couple of days—the time it takes for some debit transactions to clear—to deposit cash. But now many banks hit them with fees as soon as purchases are made. "Banks have turned to this as a major source of revenue," says Jean Ann Fox, director of financial services at the advocacy group Consumer Federation of America.

The practices have become so prevalent that the Federal Reserve has proposed rules that would rein in perceived abuses. The banks argue that they provide a necessary service to consumers. "There's a balancing act to ensure folks who do need to occasionally go over the limit have [the protection] while having a deterrent in place for people who abuse it," says Doug Johnson, a policy adviser at the trade group American Bankers Assn.

The Next Frontier
Regulatory headwinds haven't deterred the banks from ramping up their debit-card businesses. Among the groups that offer the biggest potential for banks: people who earn more than $75,000 a year. According to MasterCard (MA), they're the least active debit users, usually turning instead to credit cards that offer frequent-flier miles and other rewards.

To attract that crowd, financial firms are ramping up their loyalty programs. MasterCard's Savings program, launched in October, offers debit users discounts on luxury brands like Armani and 7 For All Mankind as well as at retailers such as Home Depot (HD) and Target (TGT). San Antonio's Frost Bank (CFR) recently released its Momentum card, which is connected to customers' checking or savings accounts. The bank pays customers a higher interest rate on the accounts—up to 3.5%—when they make more debit purchases.

There's also a land grab for the so-called underbanked, the roughly 80 million people who don't have a bank or credit-card account. Dallas' Comerica Bank (CMA) won the right this year to issue debit cards to the estimated 4 million Social Security recipients who don't have bank accounts. The government deposits the money onto a prepaid card. (Comerica doesn't charge overdraft fees on them.) Visa and MasterCard offer prepaid debit cards that companies use to pay employees.

The aggressive push is paying off. These days, debit cards are as widespread as credit cards. At the upscale suburban Atlanta restaurant Aqua Blue, waitresses now bring diners a device that lets them swipe their debit card and enter their password to pay for meals. "Debit is becoming the payment card of choice for the American public," says Red Gillen of consultancy Celent.

But for consumers like Garcia who want to break free from the high fees and penalties of credit cards, debit cards may not be the panacea they expected. Says consumer advocate Fox: "As with credit cards, consumers can't keep up with what the rules are."

With Brian Burnsed in Atlanta.