Credit, Debit, and Charge: Sizing Up the Cards in Your Wallet

While credit cards, charge cards, and debit cards look similar and share the same space in your wallet, they each have distinct benefits and potential drawbacks. Read on to figure out which ones are right for you.

How Credit Cards Work

Credit cards usually come with a set credit limit (say $500, $2,500, or $25,000) based on your credit history and income. They allow you to carry a balance from month to month, on which you must pay interest. In general, a credit card issuer will raise your credit limit as you spend more and make regular payments. If you habitually pay late or miss payments, your limit could be reduced or your credit cut off. The issuer might also raise the interest rate on the remaining balance.

Shop carefully when selecting a new card. An attractive offer of no annual fee might be accompanied by an exorbitant interest rate as high as 30%. If you have no credit history or a poor credit history, your best option might be a secured card. In exchange for a deposit of $200 to $500, a bank will issue a credit card with an equal spending limit. This allows you to establish credit and, if all goes well, qualify for a regular, non-secured card in the near future.

How Charge Cards Work

Charge cards are not as common as they once were, but there are still a few of them around. American Express offers charge cards (along with regular credit cards) and CapitalOne has the Spark 2% Cash Plus charge card for business owners among its many other card offerings.

Charge cards differ from credit cards in two basic ways: They typically have to be paid off in full every month (although some allow the card holder to pay for certain purchases over time) and they have no preset spending limit. That doesn't mean you can go out and run up a bill in the millions of dollars but that the card issuer will adjust your spending limit based on your purchases and other factors.

Like credit cards, some charge cards assess an annual fee and some also offer rewards. Despite the fees, some consumers prefer charge cards because they avoid the interest-related expenses that come with credit cards. In addition, charge cards impose the discipline of paying them off every month, which can discourage overspending.

How Debit Cards Work

Debit cards work something like old-school checks. When you make a purchase with a debit card, the payment is taken directly from your linked bank account. If your account has insufficient funds, your card payment may be declined. Some banks, however, offer overdraft protection that will cover a transaction up to a set dollar limit in the event of insufficient funds or transfer of the necessary funds from another linked bank account, if you have one.

Online debit cards function like credit cards. You need to provide the merchant with the card's number, expiration date, and validation code to complete a purchase. Offline, your debit card functions much like an ATM card. You need to enter your personal identification number (PIN) to initiate the transfer of funds from your bank account to the merchant's bank account.

If you want to curb your spending and avoid the urge to buy stuff you can't afford, debit cards can be a good choice. The money comes directly from your bank account. There are no interest charges and generally no fees. Visa and MasterCard affiliates issue most debit cards, so most merchants that accept Visa and MasterCard credit cards will also accept debit cards.

However, debit cards have fewer protections against fraud than credit cards, and it can be more difficult to get your money back. One other point: because you're paying with your own money and not borrowing, debit cards typically don't help you build a credit history or improve your credit score.

The Bottom Line

Credit, charge, and debit cards are a convenient way to buy things and avoid carrying a lot of cash. And if you participate in the various perks programs offered by credit cards and charge cards, you can earn airline miles or other rewards with each purchase.

From a financial perspective, debit and charge cards are structured so they pose little danger to your financial well-being. They discourage or make it impossible to carry a balance, so the temptation to buy what you can't afford is minimized.

Credit cards, on the other hand, have been an instrument of financial ruin for more than a few consumers seduced into living beyond their means. Interest rates can border on the obscene, and making only the required minimum monthly payment can stretch a purchase's payback period for years.

To avoid these pitfalls, pay attention to your spending habits. Keep in mind that being able to afford the minimum monthly payment doesn't mean you can afford the purchase. It simply means that if you buy an item, not only will you be taking on debt, but the interest payments will increase the total cost of the item to well beyond its sticker price.