The Decision between Debit and Credit: Finance Charges, Float, and Fear

Abstract We develop a simple model of a consumer's choice between using credit and debit and show that consumers are always better off using credit than debit when both types of cards are available for a purchase. This result is tested and the persistence of debit cards in the marketplace is examined using data from the 1998 Survey of Consumer Finances. Empirical evidence is presented suggesting that the persistence of debit cards in the marketplace is because of (1) the fact that even households that use credit cards without borrowing do not view credit as a substitute for debit and (2) consumers' fear of credit. © 2005 Academy of Financial Services. All rights reserved. JEL classification: D14; D12 Keywords: Methods of payment; Banking services; Debit cards; Credit cards 1. Introduction Between 1993 and 1997, the number of debit card transactions in the United States grew at an average annual rate of 53.3%. Also during this time period, the debit card's share of total non-cash transactions more than quadrupled (Weiner, 1999). From a social perspective this would appear to be good news. Humphrey, Pulley, and Vesala (2000) place the social cost of paper checks at $181 billion per year. According to that study, the payee cost per $100 of sales value for debit cards is only $0.70, while it is $1.07 for checks and $2.41 for credit cards [based on data compiled by the Food Marketing Institute (1998) for U.S. supermarkets]. Although the growth rate in the usage of debit cards reported above seems quite large, the United States lags behind other countries in the adoption of all forms of electronic payment. The question of why the U.S. lags behind other countries has thus received much attention in the literature. Recent studies have suggested that a lack of price incentives for consumers, along with supply side barriers, has led to the slow adoption of electronic payments in the United States [see, e.g., Humphrey, Pulley, & Vesala (2000); Caskey & Sellon (1994)]. Indeed, if society is to switch to the socially desirable debit card it must be consumers who decide to make the change. For this reason, we will take a different approach than the existing literature: given the availability of credit cards, why would a consumer ever choose to use a debit card? We provide a contribution to the literature on methods of payment by addressing the reasons that consumers might choose the debit card over the credit card. In many respects the two options work in the same way. Many retail locations use the same hardware to process both types of transactions, yet the credit card seems to give the consumer many more perks than does the debit card. From the payee standpoint it is obvious why the debit card is preferred since transactions costs, which are borne almost entirely by the payee, are much lower (see Caskey & Sellon 1994). For consumers, however, it would seem that credit cards would be the preferred method of payment. Because credit cards are accepted almost everywhere that debit cards are accepted and the choice of which to use belongs to the consumer, the question is not why are consumers so slow in adopting debit but, rather, why are consumers adopting it at all? A common answer to this question is that consumers avoid the of incurring high finance charges on a credit balance by using a debit card. There is, however, no exogenous risk involved in using a credit card; credit card usage involves only actions taken by rational economic agents and the certain consequences of those actions. It is possible that consumers fail to fully understand how credit cards work, and therefore, have a fear of falling into debt (or falling deeper into debt) simply by using credit. The perception of risk can then best be categorized as incomplete information regarding the consequences of credit card usage. We provide a simple model of a consumer's choice between using credit and debit and test our predictions using data from the 1998 Survey of Consumer Finances. …