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How Do Prepaid Credit Cards Work?

If you have bad credit or want to avoid using traditional credit or debit cards, a prepaid credit card is an option. Prepaid cards are easy to get, require no credit check, and can be used for online shopping or when you can’t pay in cash. The cards can be bought online and at brick-and-mortar stores.

“Prepaid cards can be purchased at banks, discount (stores) and convenience stores,” says Mike Sullivan, director of education with Phoenix-based Take Charge America, a nonprofit credit counseling and debt management agency. “They can be obtained quickly and cheaply.”

How Prepaid Credit Cards Work

Prepaid cards are different from traditional credit cards, even though both types might carry the Visa, Mastercard, Discover or American Express logos. Rather than tap a line of credit, users spend only what they load onto the card.

Prepaid cards actually work a lot like bank debit cards. Each transaction reduces your cash balance, but unlike a conventional debit card, a prepaid card is not tied to a bank account. Some prepaid cards also can be used to withdraw cash from an ATM, but you can only withdraw up to the amount loaded onto the card.

Some prepaid cards are reloadable — meaning you can add money to the card multiple times — and others are not. You also don’t need a bank account to use these cards.

“You actually are spending your money,” says Paul Golden, director of media relations for the National Endowment for Financial Education in Denver. “This is not money that’s being lent to you like with a credit card.”

[Read: Best Credit Cards for Bad Credit.]

Compared with traditional credit cards, prepaid cards can make it harder to go into debt because some prepaid cards will not authorize purchases that exceed the amount loaded on them. Those that allow you to go over your limit may charge an overdraft fee. And keep in mind that you can go over your limit if you have a low balance and a separate card fee puts you in the red.

Different Types of Prepaid Credit Cards

Prepaid cards fall into two major categories:

Open loop: This type of prepaid card is branded with the logo of a network such as Visa, Mastercard, American Express or Discover. You can use these cards anywhere the brand is accepted.

Closed loop: You can only use this type of prepaid card in specific places, such as at a particular store or group of stores.

Employers may issue reloadable open-loop cards to employees to provide pay and benefits more easily. “Some employers even offer the option of having payroll delivered to unbanked employees via prepaid cards,” Sullivan says. These cards for employees who do not have relationships with financial institutions are also known as payroll cards.

Government agencies also may use open-loop cards to pay benefits such as unemployment insurance.

The Pros of Prepaid Credit Cards

You can use the cards to put the brakes on spending. Prepaid cards can be a great tool for consumers who struggle to live within their financial means, Golden says. “Prepaid cards are useful in helping control spending and managing expenses.” You can use them to set a budget for particular expenses that you may be more likely to stick to than with a bank or credit card account.

No approval is required. The cards make sense for consumers with poor credit who can’t get approved for a credit card. “There’s no credit check to get a prepaid card,” Golden says. “Anyone can do it.”

The cards are more secure than cash. Prepaid cards offer a way to access spending money without carrying around a wallet full of bills. And new consumer protections from the Consumer Financial Protection Bureau for prepaid cards that are lost, stolen or fraudulently charged start April 1, 2019.

The cards make great teaching tools. One of the most overlooked benefits of prepaid cards is that you can use them to teach children how to manage their money. “It can be a safe environment to kind of get younger kids interacting with plastic,” Golden says.

They’re an easy way to give money. Prepaid cards can make excellent gifts, Sullivan says. Unlike store-branded gift cards, open-loop prepaid cards can be used anywhere the network’s cards are accepted, making them a more flexible option than traditional gift cards, he says.

The Cons of Prepaid Credit Cards

While prepaid cards have perks, they also have a few drawbacks.

If you don’t register your card, you may be limited in how you can use it. Before using a preloaded card, you may be required to register it with the card provider to access all of its features. If you fail to do so, you may not be able to add more money to it, use it online or withdraw funds from an ATM, for example.

You’ll pay fees to use the card. “Prepaid cards are not perfect,” Sullivan says. “There is a cost to buy them, and there can be expenses involved in using them.”

Among other costs, you might pay individual fees to activate, reload or replace the card. Charges may also apply when you use an ATM, make a balance inquiry, pay bills online, get a paper statement or have a charge declined.

[Read: Best Travel Rewards Credit Cards.]

Sullivan notes that “the most predatory cards” may even charge a monthly fee simply for keeping the card active.

Prepaid cards do not report to the credit bureaus. As a result, they do not allow you to build a credit history. Prepaid cards won’t help you establish or repair credit, except as a tool to control spending.

The cards aren’t always accepted. Prepaid cards typically are accepted wherever credit cards can be used. But Golden says you might run into challenges if you try to rent a car or reserve a hotel room with a prepaid card. Rental car companies or hotels may ask you for a cash deposit or place a hold on prepaid card funds.

You may only be able to spend what’s loaded on the card. While some prepaid cards allow overdrafts, others do not offer any way to make a payment if your expense exceeds what is on the card. “If the card does not have enough value for a transaction, the transaction will be denied,” Sullivan says.

The cards come with limited consumer protections and benefits. Credit cards may offer cardholder benefits and account protections, such as zero liability for unauthorized charges, extended warranty coverage or travel insurance. Prepaid cards don’t offer the same level of benefits or protection.

They provide less rewards potential. Prepaid cards may not offer rewards, and if they do, they’re usually at lower rates than credit cards.

Choosing the Right Prepaid Credit Card

Read the agreement that comes with your prepaid card to make sure you understand the card’s limits and fees. And when the CFPB’s new rule goes into effect, it will require prepaid card issuers to provide disclosure forms that clearly state the fees.

“Prepaid cards are not created equal,” Sullivan says. “Buyers must be careful when selecting a card.”

Some fees are especially worth avoiding, Golden says. He cites cash withdrawal fees and monthly service fees as being particularly “egregious.” “It’s up to the consumer to really understand where all the fees are assessed and if you’re able to avoid those fees,” he says. “And if not, then that’s probably not the right product for you.”

The funds attached to some prepaid cards are insured by the Federal Deposit Insurance Corp., but not all prepaid cards are covered, and some may have requirements such as registering the card. If such coverage is important to you, call the issuer to inquire about it before purchasing a card.

Also, some cards can be used outside the U.S. Others cannot, or the card will charge foreign transaction fees when used outside the country.

Alternatives to Prepaid Credit Cards

While prepaid cards might make sense for some consumers, other options could be better, including:

— Secured credit cards

— Cash

— Money orders

— Debit cards

[Read: Best Secured Credit Cards.]

For example, consumers who are hoping to build or rebuild a credit history might be better off with a secured card. This type of card allows you to make a deposit with a credit card issuer in a specific amount that acts as collateral. Your credit limit is typically the amount you’ve deposited. The deposit isn’t used to pay your bill. You’ll be required to pay back what you owe with at least a minimum payment each statement period.

Your security deposit lowers the risk for the issuer and makes getting approved for the card easier for you, even if you don’t have good credit. Secured credit cards typically report your account activity, including payments, to the credit bureaus. Regularly paying your secured credit card bill on time can help you build a positive credit history.

“Where a prepaid card is not going to help you build a credit history, a secured card will,” Golden says.

But with secured cards, the upfront expense can be a problem. While you can typically purchase a prepaid card for less than $5, secured credit card deposits range from $200 to $500.

Nevertheless, a secured card can be a powerful tool for getting your financial life moving in the right direction. Once you’ve established a good payment history with a secured credit card, you may get a credit limit increase (which might require a larger security deposit) or an upgrade to an unsecured credit card and your security deposit returned.

Other alternatives to prepaid cards include cash, money orders and a debit card. A traditional debit card is one of the best alternatives to prepaid cards, Golden says. However, getting a debit card requires having a relationship with a bank.

“There are a lot of people who use prepaid cards who want to avoid banks for whatever reason,” Golden says. “Maybe they were hit with overdraft fees and a lot of other fees, and they just ended up closing their account rather than put up with it anymore.”

Golden says he understands that some people are reluctant to take that step if they have had a negative banking experience in the past. But some comparison shopping can help you find a bank with low fees and the customer service you need, he says.

In the end, knowing yourself and your needs is the best way to determine whether prepaid cards are right for you.

“It all comes back to shopping around and doing your homework,” Golden says. “First, map out what your goals are. That’s going to help you decide which product is right for you.”

More from U.S. News

How to Convert a Secured Credit Card to an Unsecured Card

Best Prepaid Debit Cards

How to Build Credit Without Credit Cards

How Do Prepaid Credit Cards Work? originally appeared on usnews.com



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