Debit cards: Prepaid versions not a good deal

There are numerous prepaid debit card offerings out there offered by young financial services companies, the biggest of which are Green Dot and NetSpend. Numerous smaller and larger players are also vying for a piece of this growing industry, including Western Union, Visa, Discover, and RushCard.

These companies cater towards the segment of the population who are unbanked or underbanked. The cards are supposed to be a cheaper option than a bank account. But after a period of time, something strange happens. Most customers quit using their cards.

The reason? In online forums, many customers complain about losing money they’ve loaded onto the card, while others complain about paying fees they didn’t initially anticipate. In many cases, these customers would have been better off using a banking account.

For example: The most popular reloadable prepaid debit card in America, the WalMart MoneyCard, charges $3 as a monthly maintenance fee, $3 to reload the card with more cash, $2 to withdraw cash at an ATM or a bank teller, and $1 to find out your balance at an ATM.

As prepaid cards go, that’s a good deal. Other cards charge a lot more, according to a September report by Consumers Union, the nonprofit publisher of Consumer Reports. One striking example is the Kardashian Kard, which has a $9.95 activation fee and charges $7.95 per month, with a $1.50 fee to call customer support and a $6.00 fee to shut down the card.

By contrast, the Walmart card’s provider, Green Dot Financial, will waive the monthly fee for customers who every month either deposit at least $1,000 on their card or make at least 30 purchases.

Even that deal, however, doesn’t stack up to a free checking account from, say, U.S. Bank. The account has no monthly minimum account balance, no maintenance fees, and no charges to use a U.S. Bank ATM, take money out at a teller, or put money in. Capital One offers a similar free-checking deal.

Our comparison may even understate the true cost of a prepaid debit card relative to a checking account. This is because a prepaid debit card does not allow you to cash checks, whereas checking accounts provide this service for free, and many of the same people who use prepaid debit cards will likely also have to use other alternative banking services such as check-cashing services, with additional fees attached.

Why so many unbanked Americans?

Of course, all this begs the question: If checking accounts can be so cheap, why are so many people still without a bank account and drawn, instead, to prepaid debit cards?

According to the FDIC, 7.7 percent of Americans households don’t have a bank account. The top reasons never-banked households do not have an account, according to the FDIC survey:

• Do not have enough money to need account (37.1 percent)
• Do not write enough checks (18.0 percent)
• Minimum balance requirement too high (12.7 percent)
• Do not need or want account (12.4 percent)

Some people just don’t trust banks. Then there’s a small percentage of people who can’t get a bank account, typically those denied a checking account due to either bad credit or a prior history of overdrafts and bounced checks. According to the FDIC study, these 2 reasons were cited by 5.0% of never banked households, and 8.3% of previously banked households.

Until August 2010, there was also a legitimate argument that a few $35 overdraft fees each year could push the cost of a checking account higher than the cost of a prepaid debit card. However, new Federal Reserve regulations now require banks to gain customer consent before signing them up for “overdraft protection.”

To be fair, you can incur a different set of fees by bouncing checks – usually $20 to $30 from the bank and $20 to $30 from the merchant, but we believe that this is less relevant than looking at overdraft fees, which accounted for 74 percent of bank fee revenue, according to a 2008 FDIC study.

This suggests that many older comparison studies between prepaid debit cards and checking accounts are obsolete. One industry-funded study that prepaid-card companies like to point to comes from Bretton Woods Inc., which concludes that checking accounts cost more for similar services than prepaid debit cards do. But if you are willing to assume that overdrafts usually happen because of banks’ debit cards transactions, rather than bounced checks, which the FDIC believes to be the case, then the new rules should give bank customers the edge.

Prepaid debit cards offer less purchase and fraud protection

There are other reasons to opt for a bank account. Prepaid debit cards have not come under the same regulatory scrutiny as credit cards and debit cards because they hardly existed 10 years ago. Therefore, the laws surrounding minimum levels of fraud and purchase protection are minimal, and often only offer voluntary protection from the issuer, because the Federal Reserve Board, “has not yet decided whether prepaid cards… are protected under the EFT Act and its regulations” Green Dot says in its SEC filings. “[M]any issues regarding our service have not yet been addressed by the federal and state agencies charged with interpreting the applicable laws.”

For example, some prepaid companies advertise zero liability protection via special bolt-on insurance policies from Visa and MasterCard, where cardholders aren’t held responsible if someone else fraudulently uses their cards. But sometimes there are worrisome loopholes, such as exemption at the ATM and exemption when you have to punch in a PIN during a debit card transaction on a non-Visa network. This means users have to take prepaid card issuers at their word.

The WalMart MoneyCard agreement specifically states, “We are not responsible for the delivery, quality, safety, legality or other aspect of goods or services that you purchase from others with the Walmart MoneyCard,” under the Refunds and Merchant Disputes fine print.

Judging solely from the number of message board complaints surrounding unrecoverable fraud losses, we believe that in practice, their word is often an inferior level of protection relative to normal credit or debit cards.

Taking 100 prepaid card complaints at random from one of these message boards, we found that 9 percent involved money not being credited after merchandise was returned to a retailer, 35 percent involved complete loss of deposited money due to some reason or another (not fraud related), and 17 percent involved fraud-related losses unrecoverable by the issuer, which was sometimes related to the use of WalMart MoneyPaksAnother underlying theme on complaint boards revolves around the difficulty of reaching a customer service representative. Long wait times, lack of humans answering the phone, and repeatedly “lost” mail are some of the biggest reported sources of frustration with prepaid debit cards. Many simply gave up their remaining deposit amounts due to the inability to get customer service to help them.

“The customer is never able to speak with a representative to handle the problem,” writes Jurlean Fuqua, a prepaid customer in North Carolina, after her Green Dot card was repeatedly declined everywhere she tried to use it. “You are either placed on hold indefinitely or no one is available. It has been over a year now, and the money I placed on the card(s) has now been eaten up by their ‘service fees,’ even though I never used them!”

In another instance, a woman claims to have waited for 4.5 hours to reach the proper customer service representative.

Other prepaid cards, such as RushCard and NetSpend, engender similar complaints.

After several months’ experience with prepaid cards, many customers give up using them. Green Dot says its average customer used the card for nine months in the 2009 fiscal year. According to our calculations over the same period, the average customer used the card for less than six months and paid just under $14 per month. (The major difference is that we consider a card inactive once it is no longer being used, rather than once the balance drops to zero.)

There may be good reasons that some people prefer prepaid debit cards to checking accounts. Both options can run up fees for customers who don’t pay attention. But for those who are careful, the checking account seems to offer the better deal.

– Tim Chen is the CEO of NerdWallet, a credit-card search website.

Other prepaid cards have similar complaints, including RushCard and NetSpend.