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Cards, Cards and More Cards: The Evolution to Prepaid Cards

Saturday, October 1, 2011

It's almost impossible to get by today without some kind of plastic card - just try to make a hotel reservation or rent a car without one. How did we become so dependent on plastic cards and cashless payments? A look back in time reveals the answer.

The evolution to credit cards came naturally. Recall the American West, when pioneers charged items at the country store then paid their bills as they had the money. Now consider the sharecroppers of the past century, whose livelihood depended on the credit provided by landowners. Landowners supplied a "furnish" - supplies and food - for sharecroppers to plant crops and subsist. Sharecroppers then repaid their debt with a percentage of the crops harvested - an ongoing cycle.

Stores later defined credit limits and some introduced 90-day credit accounts. Customers could charge purchases, take the merchandise, then pay the bill over a three-month period without interest. Although initially store-based, such credit accounts evolved to become today's credit cards. Credit cards represent borrowed money and the agreement that the cardholder may buy on credit now and pay later. If payment isn't made by a given date, the credit card holder pays interest on the loan. The first widely accepted credit card debuted in 1950 - The Diners' Club. Cardholders of this then-paper card could charge meals with payment due in full monthly. By the mid-1950s, several companies entered the credit card market. And, MasterCard and Visa emerged successfully. In 1959, Bank of America introduced the first "revolving" charge card called the BankAmericard. Cardholders did not have to pay the bill in full monthly, but could make monthly payments toward the total, with interest applied to remaining balances.[1]

As the credit card system grew, computer technology advanced and revolutionized banking. In the mid-1980s, automated teller machines (ATMs) enabled 24-hour access to cash and account information. As consumers began to have their paychecks deposited electronically into their bank account and pay their bills electronically, banking business could be conducted without physically going to a bank at all! [2]

In 1984, banks began issuing a new tool - debit cards. Debit cards are linked to a bank account. When the card is used to make a purchase, payment is withdrawn from the cardholder's bank account. Because of the convenience of debit cards, they soon became a popular replacement for cash and checks. By 1998, consumers used debit cards more often than checks.[3]

Today, a new trend is emerging: the prepaid card. According to the 2010 Federal Reserve Payments Study, consumers conducted 6 billion transactions with prepaid cards for a total of $140 billion during 2009. From 2006 to 2009, the use of such cards increased 20 percent and the value of these transactions increased by 22.9 percent per year. Transactions using prepaid cards comprise a relatively small portion of total noncash payments but are the fastest growing option within the category.[4] This trend began in the late 1980s when prepaid phone cards appeared. These were followed in the mid-1990s by the closed-system (merchant specific) gift cards. Open-system prepaid cards began in the early 1990s, when the government replaced paper-based food stamps with Electronic Benefits Transfer (EBT) cards. Open-system gift cards were introduced in the mid-1990s.[5]


What Is a Prepaid Card?

A prepaid card looks like a debit or credit card but is not linked to a bank account and is "pay as you go." The card has a zero value until it is purchased and "loaded" with an amount of money. When a purchase is made, the amount of the purchase is subtracted from the card's balance. When the balance reaches zero, the card is empty. Some cards are "reloadable"—money may be added to the card at certain stores, online, or by direct deposit. Other cards must be discarded when the balance reaches zero. As prepaid cards gained popularity, cards emerged for a wide variety of products and services.

According to estimates from the Federal Reserve Bank of Boston's 2009 Survey of Consumer Payment Choice, about one-third of consumers have a prepaid card of some type.[6] Some cards are targeted to specific customer needs. For example, general purpose reloadable (GPR) cards may substitute for bank accounts for unbanked or underbanked individuals. Gift cards, employee incentive cards, payroll cards, and government benefit cards provide a simplified system of budgeting and money distribution. In lieu of checks and direct deposit payments, some employers and government agencies issue prepaid cards to employees and beneficiaries.


Kinds of Prepaid Cards

A closed-system prepaid card is merchant specific: The card can be used only at a single merchant or merchant chain. (Sears cards can be used only for purchases at Sears; JC Penney cards can be used only for purchases at JC Penney.) Gift cards are typically both closed system and non-reloadable.[7] Most closed-system prepaid cards are stored-value cards. The monetary value of the card is stored on the card itself via a small microchip. There is no external record of the card value on any payment network and stored-value cards are usually anonymous.

An open-system prepaid card is associated with a given electronic payment network (such as Visa or MasterCard): The card may be used at any business within the network, identifiable by a logo. The monetary value of open-system cards is maintained by the card issuer, not on the card itself. The value of the card is accessed via a unique card number embedded on a magnetic strip on the card.[8] These cards are usually issued in the name of an individual account holder.


Prepaid Card Fees

Many prepaid cards have complicated fee structures that can be difficult to understand. Fees as well as terms and conditions vary by card. Fees may be assessed for initial activation, monthly maintenance, ATM withdrawals, reloading, replacement, monthly statements, and more. Competition among prepaid card issuers and increased volume have helped lower card fees and simplify card terms; however, prepaid cards are exempt from federal consumer protection laws that apply to bank debit cards.[9] It is wise to compare prepaid card fees and question unclear terms and conditions.


Who Uses Prepaid Cards

While these cards have traditionally served the unbanked and underbanked, more and more mainstream consumers are choosing these cards to circumvent rapidly escalating bank fees. Prepaid cards have also become popular among parents of high school and college students as a means of distributing allowance. Most prepaid cards are purchased at stores, including check-cashing outlets, grocery stores, or big-box retailers such as Wal-Mart. The biggest U.S. issuer of prepaid cards is Green Dot, which sells cards through Wal-Mart and other large chains.[10]


Advantages and Disadvantages

In addition to serving as a tool for an estimated 60 million unbanked Americans[11], prepaid cards have other advantages. They require no approval process, no credit check, no bank account, and no interest payments. Those with no bank account or bad or non-existent credit histories, thus unable to acquire a credit card, can purchase prepaid cards. These cards offer similar services and convenience as a debit card or credit card and allow online payments. Some prepaid cards, generally name-brand cards, offer security when traveling because lost or stolen cards may be cancelled and replaced.

Because of the preset limit - the monetary value placed on the card - a prepaid card can help prevent debt accumulation, cultivate better spending habits, and promote budgeting. In addition, prepaid cards can serve as a tool for parents to teach children money management. Most general-purpose reloadable (GPR) cards allow users to track recent transactions online via a personal account; thus, parents can track children's spending as well. The pay-as-you-go method can also provide direction for financial decision making and goal setting - you can't spend money until you have it.

Prepaid cards can help guard against fraud. If a card is lost or stolen, it contains no personal or bank account information and no open line of credit linked to the card - your bank account can't be drained and your credit can't be ruined. In addition, prepaid cards can be safer than carrying a large amount of cash, yet still provide quick access to cash in an emergency.

Prepaid cards do, however, have downsides. You do not build a credit history from using a prepaid card[12], and a credit history can be helpful when applying for loans or credit cards. Fees vary from card to card and may be costly, especially because prepaid cards are less regulated than credit cards. Most prepaid cards charge a start-up fee, which can be minimal or substantial. Another downside is that some businesses that accept automatic payments from banks or credit card accounts will not accept them from prepaid cards.[13]

Presently, no law requires an issuer to provide refunds for lost or stolen cards, although some cards do provide this safety net.[14] Most closed-system cards cannot be redeemed for cash, creating a use-it-or-lose-it scenario. The unredeemed balance of any card is retained by the card issuer.



GPR card issuers are not always required to provide the same consumer protection as debit card issuers. The market dynamics and industry competition among GPR cards, however, have resulted in GPR card issuers offering greater consumer protections than provided with closed-system prepaid cards, such as gift cards. Non-reloadable gift cards, whether closed-system or open-system, are generally not registered in the name of the account holder and, therefore, lack consumer protections - there is no recourse for lost or stolen cards. GPR card issuers, however, uphold the same voluntary zero liability protection policies applied to credit and debit cards within the same network: [15]

  • American Express: As long as transactions are reported within 60 days of discovery, consumers are not liable for fraudulent transactions.
  • Discover: Consumers are protected with a $0 fraud liability guarantee.
  • Visa: As long as cardholders have not been negligent or fraudulent in the handling of the card, they will not be liable for fraudulent transactions.
  • MasterCard: Consumers are protected with zero liability only on signature transactions if the card is in good standing, and if the consumer has taken reasonable care to protect the card and has reported no more than two incidents of unauthorized uses in the previous year.

Some banks that issue GPR cards offer the same protection provided with debit cards: a $50 maximum liability if the cardholder notifies the bank within two days of discovering the unauthorized use and a $500 maximum liability if the cardholder notifies the bank within 60 days.[16] Consumers should read the cardholder agreements to better understand the terms, including each issuer's liability policy for unauthorized transactions.


Government Usage

Federal, state, and local governments continue to expand their use of general–purpose prepaid cards to reduce costs and provide convenience for recipients. Although estimates vary, the savings from using prepaid cards to provide government benefits instead of issuing and mailing checks are substantial. Some estimates are as high as a 75 percent savings on disbursements[17]while others estimate the prepaid card saves the government about $0.93 on each electronic transfer.[18]

In December 2010, to further increase savings, the U.S. Department of the Treasury mandated that all government benefits be paid electronically. Effective May 1, 2011, all non-tax payments for new benefit recipients must be made via electronic deposit to a bank account; existing recipients have until March 1, 2013, to switch to the new system. Recipients (new or existing) who do not provide bank-account information for direct deposits will be issued a Direct Express card or a prepaid card of the recipient's choice as long as certain requirements are met.[19]

The Direct Express card, issued on behalf of the Treasury, is used to disburse federal benefit payments for several agencies. For example, the Social Security Administration, the largest user of the card, provides benefits including Supplemental Security Income (SSI) payments to about 1.5 million cardholders.[20] Other payments provided through the Direct Express card include veterans and military benefits, wages for federal employees, and unemployment benefits.

Additionally, the U.S. Treasury initiated pilot programs to leverage general-use prepaid cards for federal tax refunds in 2011. One program offered electronic delivery of 2010 federal tax refunds via a "MyAccountCard" prepaid card. Taxpayers could have their tax refunds deposited directly onto the cards. The second pilot program was designed to encourage current and potential payroll card users to elect to have federal tax refunds deposited directly onto general-purpose payroll cards.[21]A payroll card is a type of prepaid card that allows direct deposit of earnings to a card, rather than a bank account.


Durbin Amendment and Reform

For each payment card transaction, the issuer of the card charges the merchant who accepts the card an interchange transaction fee, or "swipe fee." These fees are set by Visa and MasterCard and passed on to the banks that issue the cards. These fees vary widely by card and in some cases are considered excessive. In the past, debit card transaction swipe fees paid by merchants to card issuers averaged 44 cents. The Durbin Amendment, which is part of the Dodd-Frank Act, directs the Federal Reserve to address these fees as follows:

The amount of any interchange transaction fee that the issuer may receive or charge with respect to an electronic debit transaction shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction.[22]

The Federal Reserve capped the swipe fee at $0.21 effective October 1, 2011.[23] This cap could cut card issuers' annual revenue from swipe fees in half.[23] Cards issued by banks and credit unions with less than $10 billion in assets are exempt from the cap. Reloadable prepaid cards are exempt as long as card transactions are the only means to access the funds underlying the card .i.e. a prepaid card that offers check writing privileges is not exempt. Prepaid cards marketed or labeled as a gift card or gift certificate are not exempt either. Considering the popularity of prepaid cards, banks may look to the prepaid card market to replace lost revenue.



As technology advances, payment systems and business opportunities will continue to evolve. The challenge for consumers is to stay informed, read the terms for any prepaid card carefully, and know the fee structure. Above all, read the fine print!

What's next? It's reasonable to assume that the prepaid card market will continue to grow and the electronic payment system will continue to replace traditional paper-based methods.

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