Are debit cards evil too?

This post is from Adam Baker, a staff writer at partner blogger J.D. Roth’s Get Rich Slowly.

Several weeks ago, The New York Times featured an article callled "Overspending on debit cards is a boon for banks." While I usually favor personal-finance blogs over the larger online media networks (call me partial), this piece was particularly compelling to me. It does an excellent job of shedding light on a topic that is positioned to be the next major debate in our government’s quest for banking reform.

• Bing: Congress considers action on debit card fees

As many other sectors of the banking industry continue to underperform, debit cards have stepped up to become an essential profit center for banks. Fees associated with overdrafting checking accounts are expected to exceed $27 billion this year. In comparison, the article predicts only $20.5 billion in credit card fees, which is likely to drop even further in the years ahead as recent government reform will require consumers to opt in to over-the-limit charges.

Note: The $20.5 billion does not include interest on outstanding balances within the credit card industry. The comparison is only of the fees related to the use and limits of the different types of cards. If you were to take into account interest, this match wouldn’t even be close. Credit card profits demolish those of the debit card industry.

While the majority of the article is fantastic, in spots The New York Times tends to go out of its way to demonize debit cards as compared with credit cards. For example:

According to (a 2008) FDIC study, a $27 overdraft fee that a customer repays in two weeks on a $20 debit purchase would incur an annual percentage rate of 3,520%. By contrast, penalty interest rates on credit cards generally run about 30%.

The math here is a little foggy. They calculate the APR assuming that the $27 overdraft is based only on the one $20 purchase, while basing the credit card fees on the entire balance on the card. Of course, if you went over the limit on your credit card on a $20 purchase and got charged a $27 fee, the percentage would be very similar (usually even more with interest).

Fuzzy math aside, there’s little doubt that the nature of these fees can be steep. The most severe problems tend to be when multiple smaller charges are allowed to pass through and each slapped with the same fee. The resulting chain of fees can quickly add up to hundreds of dollars.

J.D.’s note: Between the time Baker submitted this article and the time I’ve been able to publish it, there have actually been some changes. As Flexo at Consumerism Commentary noted, some banks are beginning to allow customers to opt out of overdraft protection -- and the fees that come with it.

The 'benefits' of overdrafting
The banking industry continues to take the stance that the ability to overdraft is offered as a convenience or a benefit. They claim that allowing you to overdraft could actually prevent you from violating a contract, paying higher interest, or being charged with late-payment fees. In addition, you would avoid the embarrassment or hassle that could come with having your debit card rejected at the point of sale. From The New York Times article:

“Everyone should know how much they have in their account and manage their funds well to avoid those fees,” said Scott Talbott, chief lobbyist at the Financial Services Roundtable, an advocacy group for large financial institutions.

I completely agree that the end responsibility rests solely on the consumer. If I overdraft my account, I am the one responsible. We shouldn’t be searching for a scapegoat or shifting the blame.

At the same time, the issue becomes much more complicated when consumers are required to have overdrafting enabled on their accounts. Many are simply wanting the banks to be more clear and upfront with their fees, allow consumers to opt out of the so-called “benefits” of overdrafting, or at least be informed when making a purchase that the account has been overdrafted.

Should the government intervene?
Many point to the recent Credit CARD Act of 2009, which stipulates that consumers will soon have to opt in to allow the limits of their credit cards to be exceeded (and incur the fees). They suggest similar legislation should mandate that debit card customers be required to opt in to the process of overdrafting. At the very least, they want all banks to offer consumers the opportunity to opt out.

On the flip side, The New York Times provides evidence from economists who suggest that tighter government restrictions could cause a serious ripple effect in the banking industry. For a large percentage of banks, their profit margin is less than the amount they collect in fees related to overdrafts. Any restriction on collecting those fees would force banks to immediately make up this revenue elsewhere, and many have suggested monthly fees on checking accounts would be an inevitable result.

The problem seems to be primarily concentrated within a small percentage of the consumers who take advantage of these products:

Ninety-three percent of all overdraft charges come from 14% of bank customers who exceeded their balances five times or more in a year, the FDIC found in its survey.

Should the 86% of consumers who use debit and checking products responsibly pay monthly checking fees to support the individuals who struggle? Should we allow the banks to prey on the 14% who are struggling to handle their accounts responsibly, so that we can obtain the benefits of these products for free? Obviously, there is no simple answer.

Scummy banking practices
The New York Times article also details the practice of banks reordering transactions in situations when an overdraft occurs. For example, many banks will change the order of purchases to prioritize the largest transactions.

The banks claim that many consumers would rather their larger bills, such as car, house, or utility payments, be paid first. However, there are ample cases in which tacking the smallest charges on last dramatically increases the number of overdraft charges. In fact, this practice actually maximizes the amount of fees the banks can collect.

J.D.’s note: Longer ago, I had firsthand experience with this chain of fees. The banks order your transactions in such a way as to cause multiple overdrafts, if they can. It’s not fun when it happens to you. (Biking to the store the other day, I overheard a woman telling a friend that this very thing had just happened to her.)

In addition, The New York Times ran a follow-up article, "Hurry up and credit my account." This piece details the current regulations on how long and how often banks can hold your incoming deposits. Many accuse the larger institutions of taking advantages of loopholes to hold back deposits longer, thereby increasing the potential for overdraft fees.

In the two specific cases above, I have no problem with government intervention. I would support legislation that required banks to process all expenses in the order they were received (for better or worse) and required increased transparency and consistency on the placement of holds for incoming deposits.

Is debit the new credit?
I continue to return to one thing in this discussion. For me, once debit cards enable you to spend more than is available in your checking account, they become credit cards. It’s really that simple, right? What happened to actual debit cards along the way?

Here in New Zealand, I have a true debit card. There is no Visa or MasterCard logo. I can’t use it for online purchases. However, it is accepted at all point-of-sale vendors (and ATMs). What happens if I try to charge something for which no funds exist? It’s rejected! Gasp!

I find the debit card situation here refreshing -- both in theory and practice. What about you? What do you think about overdraft fees being such an essential profit center for banks? Is this another industry where you would support government intervention? Share your thoughts below.

Related reading at Get Rich Slowly:

• How those evil credit cards can be good for you
• Why I applied for a credit card (and why it's not the end of the world)
• Leave your ATM card at home

Published Oct. 5, 2009