Prepaid Debit Cards Are Riskier Than Checking Accounts

Thanks to heavy marketing campaigns, including endorsements and partnerships with everyone from Russell Simmons to Kim Kardashian to Suze Orman (it’s hip! it’s popular! it’s financially smart!), use of prepaid debit cards has surged.

Prepaid debit cards were once a fringe financial product. They were intended to be used by people who have a communal distrust of banks, which could be understandable, as the financial industry has done little to gain the public’s trust throughout the recession and after receiving a massive bailout from taxpayers.

If not by those who distrust the industry, prepaid debit cards would be used by those who believe they can’t afford to keep minimum balances deposited in a bank to avoid costly monthly fees.

The fees for using prepaid debit cards often end up higher, but seem less of a burden day-to-day. This is the fast food effect. When you can’t put together $70 to buy groceries for the week for your family on any particular day, you buy $15 in fast food for the family, which lasts a meal. It costs more in the long-run, but the $15 is manageable on any particular day while the $70 is not. Prepaid debit cards operate on the same principle. Despite the availability of free checking accounts as well as free interest-bearing savings accounts, customers are often subjected to unexpected fees and minimum required balances that make the accounts and their potentiality for a lack of costs seemingly out of reach.

When you deposit money into a checking or savings account at a bank, including legitimate online banks, you can be sure of several things:

• Your account will never lose value. As long as the bank is insured by the FDIC, and all legitimate national, regional, local banks are, when you have $100 at the bank, that money will always be yours. You will always be able to get to it when you need it. Credit unions, like banks, have insurance as well.
• You will automatically get your money if your bank fails. Banks go under. As we saw throughout the recession, many banks, regardless of size, go under. But thanks to FDIC protection, customers get their deposited money back easily or a new bank takes over the account.

According to an article by the former chairperson of the FDIC, Sheila Bair, many prepaid debit card accounts have no such protection. Issuers of prepaid debit cards can choose whether they want to protect their customers using FDIC insurance — the more expensive choice — or through a patchwork of protections that differ by state. Many choose the least expensive option.

When you add money to your debit card account, often called “loading” or “reloading,” not “depositing,” you are giving the company issuing the card free reign to do whatever it likes with your money. Bank offering “deposit” accounts (checking accounts and savings accounts insured by the FDIC) have certain restrictions these card companies do not. Banks must not use deposited funds to invest in anything riskier than money market funds, nut prepaid debit card issuers can use customers’ money to invest in anything they like, even risky investments that might lose money.

If a prepaid debt card issuer fails and the customers’ accounts are not covered by FDIC, you might have to take legal action to get your money back. With FDIC, this is an automatic process and doesn’t cost a cent to customers. There is no such easy process for prepaid debit card holders, who might have to pay for legal representation of experience delays before seeing the money they loaded onto the debit card of a failing company.

Bair points out that state protections are not as comprehensive as FDIC insurance:

“If the prepaid card company has invested its customers’ funds in securities, which have lost their value, the only protection those customers will have is the surety bond. In Alabama, for example, customers are collectively protected up to $50,000. In Florida, they are collectively protected up to $2 million. These amounts do not represent the compensation given to each customer. They represent the upper limit for the entire class no matter how many prepaid cards have been issued or how much money has been loaded on them. Three states — Montana, New Mexico, and South Carolina — do not guarantee any repayment.”

Customers can have up to $250,000 in one bank (or $500,000 if half is within a joint account) with full FDIC insurance coverage. You can deposit as much as $250,000 without any concern about whether your money will survive a financial meltdown. In some states, if the company issuing your prepaid debit card goes under, you could get nothing back, and it’s legal.

To be fair, Sheila Bair is, as mentioned above, the former chairperson of the FDIC, so there is adequate reason to suspect she would be in favor of FDIC insurance. Nevertheless, this could be an important point to consider before signing up for a prepaid debit card. Although average prepaid debit card balances are less than savings and checking account balances, you don’t want to be stuck fighting for your money back in the event of another financial crisis.

Prepaid debit cards have several strikes going against them:

• Prepaid debit cards are more expensive in the long-run.
• Prepaid debit cards are riskier than checking and savings accounts.

Despite their rising popularity, these reasons are enough for me to not recommend them. Some might offer cash back rewards, but they are hardly worth the variety of fees almost always associated with using the card. Free checking accounts with free debit cards are available from reputable financial institutions. You can find some that have low or no minimum balance requirements. Those are almost always better options.