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Debit or credit? Here's the answer

Paper or plastic? Credit or debit? These are the questions that haunt consumers as they head to the checkout line every day. I can't help you with the bags, but I can ease your burden on question number two. With only a few exceptions, you are better off sticking with credit cards and using debit card only to get cash at ATMs.

I've been preaching that for years, and now Consumers Union is preaching it too, in a piece called "The Darker Secrets of Debit" published in the September issue of Consumer Reports Money Advisor newsletter.

Before I lay out the argument for credit cards, let me clarify for you the difference between credit and debit. It's not what you think.

Banks and retailers have done their best to muddy what should be a very straightforward question for consumers – pay now or pay later? The reason is money, of course. It might seem like a simple question to you, but billions of dollars ride on the distinction.

Here's the first surprise: "Debit or credit?" is actually an unfair, misleading question. There is no such thing as a debit card that's used as a credit card. When you hand over a debit card, you are engaging in a debit transaction no matter how you answer. When clerks ask this question, they are really asking you to pick one of two ways they can process your debit – a PIN (personal identification number) based transaction or as a signature-based transaction. One costs the merchant a little more and one takes a little longer to hit your checking account, but fundamentally a debit transaction is a debit transaction.

For all the reasons cited below, you want neither. So when I say pick credit instead of debit, I don't mean tell the clerk to use your debit card like a credit card. I mean put away the debit card you use to get money from the bank and pull out a true a credit card instead.

On to the reasoning:

Bounced checks. Debit card users are hit with more overdraft fees -- a lot more. Many consumers don't realize that a bank will approve debit transactions even if they have insufficient funds in their account. Then the bank tacks on a $35 overdraft fee, which doesn’t become apparent until the end-of-month statement arrives. That means a $5 hamburger can easily become a $40 hamburger.

Being addicted to debit can actually be more expensive than being addicted to credit. Consumer Reports says those who pay with debit cards 20 times or more each year pay an average of $223 in overdraft fees, compared to just $40 for those who don't use debit cards at all. The Center for Responsible Lending says that most overdraft fees now result from debit transactions rather than bounced checks. Banks make more than $10 billion this way every year.

Extra fees. Some stores charge 25 cents to $1 for use of a debit card, though such fees are slowly disappearing.

“Blocking” surprises. Paying for car rentals, hotels and gas stations with debit cards also can cause your account to be overdrawn, as retailers often withdraw more money than you've actually spent, then put some back later. It's a practice called 'blocking." Car rental firms can actually block off hundreds of dollars extra, to make sure the consumer has enough in their account to pay for possible added charges. The blocked funds are never really transferred to the retailer, but they aren't available to the consumer, either. Instead, they reside in a kind of financial limbo.

Run a few such transactions on a vacation and you might run out of cash and be unable to get money from an ATM, or be hit with overdraft fees. Blocking also occurs with credit cards, but it has no impact on consumers unless they are precisely up against their credit limit.

Consumers who insist on using debit cards to pay for rental cars should reserve the car with a credit card and switch to debit when they pay in order to avoid checking account blocking.

Immediate withdrawal of funds. Judicious use of a credit card amounts to a free 30-day loan, whereas using a debit card (signature-based or PIN-based) means the money exits your bank account right away. Using a credit card lets you keep your cash in an interest-bearing account for an extra 30 days. Over a decade or more, that adds up.

Fraud protection. Federal law affords credit card consumers better protection than debit card users. Credit users' obligation is capped at $50. Debit users can be on the hook for $500 if they don't report fraud within two days of learning about it and face unlimited liability if they wait more than 60 days. In practice, both debit and credit users generally enjoy zero liability guarantees from their banks, but those generous debit policies can be changed at any time. Consumer protection under the law is a safer bet.

Fraud recovery. Getting money back in the event of fraud is much easier for credit customers than for debit users. When a criminal uses your credit card, all you have to do is refuse to pay for the fraudulent purchases. When a debit card is stolen, the money disappears from your account, and the burden is on the consumer to call the bank and get that money replaced. Anyone who's ever logged online to see a zero balance or been denied cash at an ATM after an incident like this will tell you that is no small distinction.

When there's a big data theft, such as in the TJ Maxx case, you'll really wish you used your credit card. Even though the criminals don't have your PIN, they can still perform signature-based debit transactions with your card and drain your account.

Hacking hazards. As we learned in the last year, hackers have trained their sights on merchants as the weak link in the ATM network. There have been a few high-profile thefts where criminals hacked store hardware or processing computers and made off with consumer PINs. In general, bank security is better than retailer security. Gartner Group bank security consultant Avivah Litan recommends using your PIN with as few merchants as possible to reduce the odds it will be stolen.

Rewards programs. Such programs tend to be more generous to credit card holders than debit card uses, Consumer Reports says.

As with all rules, there are exceptions.

Many personal finance writers recommend debit cards as a better tool for controlling spending than credit cards.

When zero balances caused transactions to be automatically denied, that was valid advice, but that is no longer the case. Still, for those who just can't control credit card spending, or those whose credit scores keep them from qualifying for a low-interest credit card, debit cards can be a useful alternative.

Similarly, consumers with high balances or high interest rates on their credit cards should stop using the cards until they are paid off. Turning to a debit card then can be one way to avoid adding to credit balances.

Finally, Bank of America last week reminded all of us how expensive money can be, raising ATM fees to $3 a pop.

"Cash back" debit transactions can be one way to evade this fee. If your bank doesn’t have an ATM nearby, you can buy a pack of bubble gum and ask for $20 cash back from a merchant who doesn't charge debit fees. At the same time, remember the advice above: It's best to limit the number of times you use your PIN.

If credit cards are usually the better alternative, why are so many people nudging you toward using your debit card? And why are debit transactions more popular than credit?

The answer lies in who gets the cut.

With each plastic transaction, a merchant pays a few pennies per dollar to someone. During the course of a day, those pennies add up. From the merchant's perspective, they add up much faster if you use a credit card rather than a debit card. According to Consumer Reports, stores pay about 20 cents for PIN-based transactions on a $100 purchase, but $1.48 if the transaction is signature-based. That means the retailer pays the bank more than seven times as much, and explains why some banks charge consumers extra for debit transactions, to nudge them toward signing the slip (picking “credit”) rather than entering a PIN.

On the other hand, when you use a credit card, the bank where you have your checking account is cut out of the loop. Instead, the credit transaction fees go to the card-issuing bank. In other words, if you hold a Bank of America debit card and a Capital One credit card, your small choices have a big impact on their bottom line.

The nudging by banks has worked. Earlier this decade, debit card use surpassed credit card use, both in transaction volume and in total dollars. Debit cards are now equally as popular as cash, and are poised to surpass all payment mechanisms soon. Visa reported last year that more than $1 trillion had been spent worldwide using debit cards, much of it one $3 latte at a time, as consumers become increasingly comfortable pulling out plastic instead of small change. A recent marketing campaign portrays plastic as quicker than cash, showing an embarrassed fast-food buyer holding up the line while digging for quarters in his pockets.

But not all plastic is created equal. In this case, the minority is right. For most people, credit it better than debit.

For much more information on the differences between credit and debit, see the Consumer Report Money Advisor September edition.