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Bridges | Spring 2012

Paper or Plastic? The Potential Impact of Prepaid Cards on Personal Financial Management

Do you remember the television commercials where customers are dancing through the checkout line and one person stops everything in order to pay with cash? Although those commercials seemed far-fetched, they represent an emerging truth: We are becoming an increasingly cashless economy.

For the unbanked, our booming affinity for “plastic” can exclude them from everyday transactions, including making online purchases and paying bills by phone. Fortunately, stored-value cards, commonly known as prepaid cards, can help fill the gap between the cash and the cashless segments of society that now exist.

Prepaid cards function similarly to a debit card, but are not linked to a traditional bank account. The majority of prepaid card users are unbanked for a variety of reasons, including lack of proximity to bank branches, distrust of financial institutions, the need to maintain required account balances, and the inability to avoid or repay bank fees. Prepaid cards can be purchased from nonbank retailers such as grocery stores, large box retailers and online merchants. Funds can be reloaded at these locations or through direct deposit. Most of the cards are also branded by a major credit card company and are accepted anywhere that company’s card can be used. (For more information on prepaid cards, please refer to www.stlouisfed.org/publications/itv/articles/?id=2168.)

According to the 2010 Federal Reserve Payments Study, prepaid card transactions accounted for five percent of all noncash transactions and were the fastest-growing type of noncash payment method, with a transaction frequency increase of 21.5 percent in three years. The FDIC estimated in 2009 that of the 25.6 percent of U.S. households that were under- or unbanked, more than 35 percent utilized some sort of prepaid card for general spending purposes. The Mercator Advisory Group found that funds loaded onto prepaid cards totaled more than $42 billion, a 50 percent increase from 2009 to 2010. Usage rates of these cards can only be expected to rise.

Goodbye Envelopes (Prepaid for Budget Management)

Proponents of prepaid cards laud them as an effective financial management tool. One participant in a 2009 focus group for the Center for Financial Services Innovation explained, “I primarily use reloadable prepaid cards for items like gas, groceries and smaller bills like phone or Internet services. It’s easy to place the money into the account during the month and stay within the confines of the budget I have allotted to spend for these goods and services.” The convenient loading of funds to these cards makes money readily accessible and lowers time spent and costs for basic transactions. (See “Sample Potential Savings Using Prepaid” chart below). Some cards even feature high-tech “envelope method” management systems through online platforms that allow users to monitor their spending and create budgets (see sample online tracker below).

Sample Potential Savings Using Prepaid

John receives income from six checks per month, totaling $1,700. He uses cash to pay his rent, and money orders for his phone, cable and car insurance bills. He makes five additional monthly purchases for groceries and eating out. Below is a table showing sample monthly financial services costs utilizing three different options. Note that while a checking account could be the most cost-effective, potential fees could wipe out the savings.

Sample Potential Savings Using Prepaid

SOURCE: Adapted from The Nonprofit’s Guide to Prepaid Cards, Center for Financial Services Innovation.

Sample Online Spending Tracker for Prepaid Cards

Some prepaid cards feature management systems that allow users to monitor budgets. In this example, the red part of the line indicates how much of the budgeted amount has been used; green is still available.

Sample Online Spending Tracker for Prepaid Cards

SOURCE: Adapted from www.NetSpend.com.

Many prepaid card users view the perceived fee transparency of these cards as a benefit. As a November 2011 National Public Radio segment pointed out, many consumers are frustrated with the penalty fees associated with bank accounts and would prefer to know the true cost of transactions ahead of time. In general, checking accounts are the most cost-effective, but for consumers who are short on funds, one overdraft charge can have a significant financial impact; prepaid card users avoid these fees altogether. Unfortunately, these same per-transaction charges make the true cost of the prepaid card hard to calculate and can reduce the user’s purchasing power. Additionally, non-bank-issued cards are not FDIC-insured, increasing a consumer’s risk to losing loaded funds. Since this industry remains largely unregulated, it is important for consumers to research products prior to purchase.

Saving for a Rainy Day (Asset Building With Prepaid Cards)

Prepaid cards are an innovative tool providing the unbanked with access to basic financial services. However, these products are far from a panacea. First, few of these cards offer savings vehicles for consumers; in fact, because the funds are readily accessible, they can actually be a disincentive to save. Some card companies have introduced optional savings features on their cards, like NetSpend’s National Savings account, the Approved Card’s savings goal funds, and overdraft protection. However, the provision of these services depends on the card issuer, and utilization rates are unclear.

In addition, these cards presently offer no credit-building benefits to consumers who may lack sufficient credit histories. Despite appeals from prepaid card companies, the credit bureaus have been reluctant to create standard data reporting formats for “noncredit” transactions. TransUnion has indicated movement toward these capabilities, but it is unclear whether Equifax and Experian will follow and how prepaid cards will be factored into the FICO score calculation. Until these systems are established, low-credit individuals would benefit more from using secured credit cards for credit-building purposes.

Taking it to the Bank (Prepaid as an Introduction to Traditional Banking)

Although the safety and cost-effectiveness of these cards are vague, one thing is certain: Prepaid cards are here to stay. With employers and public benefit payers shifting toward electronic payments to reduce costs, utilization rates of these cards will continue to rise. In the future, competition within and regulations of prepaid card providers will increase, making these cards a safer and more affordable product for consumers.

The rapid growth in the use of prepaid cards as “proxies” for checking accounts demonstrates the need for financial products suitable for the lifestyles of under- and unbanked individuals that are appropriate for meeting current banking needs. It is up to the regulated financial services sector to continue creating safe, affordable and innovative products to fill these gaps—and to see prepaids as one route among many to build access to wealth-building financial services for everyone.

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