Prepaid cards - plastic where the consumer pays up front rather than later - were one of the fastest growing innovations in personal finance in 2009. The cards have a lot going for them, namely convenience and security. However, they also have a severe downside. In this article we'll look at the pros and cons of prepaid cards.
When You Can't Get a Credit Card …
Prepaid cards are tailored for people who either can't or won't deal with a traditional bank. A large section of the market are people who can't get a bank account because of credit worthiness, but it also includes students, teenagers and everyday people who want a way to shop online or something more secure than a pocket full of cash. For this reason, prepaid cards may one day push out checks and check cashing shops as the main financial tool for people without bank accounts. One of the pros of a prepaid card is that the cash is paid up front, so it's more difficult to get into debt trouble - although some allow an overdraft on the card. (Take advantage of the deals banks offer, and find the right account for your financial situation, read Bag The Best Bank Account.)
Prepaid cards have many of the same perks as credit cards. This includes internet purchases, as these cards limit the cash people can get at if they gain access to your card. Also, prepaid cards can be used when renting hotel rooms or cars that require a preauthorization. That said, prepaid cards don't offer better protection than credit card companies. Arguably, the traditional credit card is better protected because complete refunds are given when online fraud occurs. In practice, however, getting refunds from a prepaid company or a credit card company may not be as easy or stress free as it's represented. So, a prepaid card offers more security than cash, less debt-related temptations than credit, and a decent online shopping tool. (Learn more in Am I responsible for fraudulent charges on my credit card?)
The Downside: Fees
The downside of prepaid cards becomes apparent when you look at their income streams. These cards take the money up front, and thus have no need to charge interest rates like a traditional credit card. Normal lending institutions pay interest for the benefit of holding your deposits; savings accounts, for example, give a very small interest rate. In return the bank can use your money to lend at a higher rate. Paying fees up front seems counterintuitive.
Prepaid card contracts are as convoluted as cell phone contracts, with a litany of fees in the fine print. For some cards, the activation fee can only match a year's worth of regular bank account fees – hardly what you'd expect from an industry pitching itself as a way to save on bank account and overdraft fees. Using a prepaid card regularly can mean paying fees for purchases as well as fees for paying bills, calling customer service, receiving account updates, and shortages - a sneaky way of not admitting to an overdraft fee. (For more on understanding you r monthly statement, check out The Ins And Outs Of Bank Fees.)
Paying High Prices for the Cheaper Alternative
Simply put, prepaid cards fall short when compared to a debit card or even a credit card. They're not significantly more secure - and if the number does get stolen, expect a fee when you call to report it. They also don't help you build any credit.
One situation in which prepaid cards are a cheaper alternative is when your bank account is constantly overdrawn and consequently racking up fees, or your credit card is carrying a large balance. Prepaid cards, despite their swarm of stinging fees, don't cut as deep as a bank or credit card company can when they think you're a bad risk. Prepaid cards, in this case, will save you money - that is, cost you less by comparison - but they won't fix the underlying problems that are keeping you in a state of near financial ruin. (You might want to read Should You Close Your Credit Card?)
If at all possible, having a bank account and a debit card that you don't overdraw is the best way to go. If banking fees keep you up at night, look to online banks that charge little to no fees. Prepaid cards are currently playing a role very similar to loan sharks, by providing banking services to people who either have no options or are unaware of the alternatives. Loan sharks at least provided credit, albeit at horrendous interest rates, whereas prepaid cards charge you to use your own money.
The prepaid cards industry is still in it's infancy, so there's hope for improvement. Bigger players are forcing fees down as they enter in with their own cards, and consumer protection groups are lobbying to curb some of the expenses. As with anything, you have to balance the pros - convenience and security -with the con of high fees. Despite its vulnerability to theft, cash provides a no-fee alternative to the prepaid card companies' nickel and diming, and cash also doesn't require a bank account or a good credit rating.