A:

Debit cards and credit cards work in similar ways. Both carry the logo of a major credit card company, such as Visa or MasterCard, and can be swiped at retailers to purchase goods and services. The key difference between the two cards is where the money is drawn from when a purchase is made. When a consumer uses a debit card, the money comes directly from his checking account. When he uses a credit card, the purchase is charged to a line of credit for which he is billed later.

Consider two customers who each purchase a television from a local electronics store at a price of $300. One uses a debit card, and the other uses a credit card. The debit card customer swipes his card, and his bank immediately places a $300 hold on his account, effectively earmarking that money for the television purchase and preventing him from spending it on something else. Over the next one to three days, the store sends the transaction details to the bank, which electronically transfers the funds to the store.

The other customer uses a traditional credit card. When he swipes it, the credit card company automatically adds the purchase price to his card account's outstanding balance. He has until his next billing due date to reimburse the company, by paying some or all of the amount shown on his statement.

With most credit card companies, the customer has 30 days to pay before interest is charged on the outstanding balance, though in some cases, interest starts accruing right away. Interest rates on credit cards are notoriously high (they are key way the credit card companies make money). Savvy consumers avoid paying it by settling their balance in full each month.

The Debt Instrument Difference

By definition, all credit cards are debt instruments. Whenever someone uses a credit card for a transaction, the card holder is essentially just borrowing money from a company, because the credit card user is still obligated to repay the credit card company.

Debit cards, on the other hand, are not debt instruments because whenever someone uses a debit card to make a payment, that person is really just tapping into his or her bank account. With the exception of any related transaction costs, the debit user does not owe money to any external party: The purchase was made his or her own available funds.

However, the distinction between debt and non-debt instruments becomes blurred if a debit card user decides to implement overdraft protection. In this case, whenever a person withdraws more money than what is available in his or her bank account, the bank will lend the person enough money to cover the transaction. The bank account-holder is then obligated to repay the account balance owed and any interest charges that apply to using the overdraft protection.

Overdraft protection is designed to prevent embarrassing situations, such as bounced checks or declined debit transactions. However, this protection does not come cheaply; the interest rates charged by banks for using overdraft protection are as high, if not higher, than the ones associated with credit cards. Therefore, using a debit card with overdraft protection can result in debt-like consequences.

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