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Millennials See Pros of Prepaid Cards but Should Weigh the Cons

April 16, 2015
Credit Cards
5 Things Millennials Have Wrong About Retirement
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A third of millennials have used a prepaid card, compared with a quarter of Americans overall, according to a TD Bank survey released this month. Earlier, a 2014 Wells Fargo study found that four in 10 millennials said they were overwhelmed with their debt load.

For young Americans, the popularity of the prepaid card may look like an opportunity to avoid debt and overspending. But there are drawbacks to prepaid cards that should also be considered.

Where prepaid cards fall short

Fees: Depending on the prepaid card you have, you can be assessed a fee when activating your card, loading money, withdrawing cash from an ATM or even checking your balance — along with a monthly maintenance fee. Some prepaid cards are lighter on fees, but on many cards they add up.

Building credit: Prepaid cards are appealing to people with bad or no credit because they don’t require a credit check. The downside: A prepaid card will do nothing to build positive credit history because you’re not drawing money from a line of credit. Without that credit relationship, prepaid-card users with bad or no credit history may still find it difficult to obtain a loan in the future.

Rewards: If you’re not in danger of overspending and don’t have a negative credit history, you could be missing out on the rewards that many credit cards offer. Although credit card rewards aren’t a way to get rich quick, they can provide worthwhile incentives for responsible credit card use.

An alternative to consider

If you’re trying to avoid credit card debt or if a bad credit score precludes you from getting a credit card, a secured credit card can help you build your credit as you practice good credit behaviors.

From day to day, you won’t notice the difference between a secured credit card and an unsecured credit card. But there’s a key difference: A secured credit card is backed by a collateral deposit. For example, if you want a $2,000 credit line, you would typically need a $2,000 deposit. That way, the card issuer can draw on that collateral if you default on your payments. Also, you can get your deposit back when you close your account.

If you have bad or no credit, a secured credit card is a better option than a prepaid card because most secured credit card issuers report your usage to the three national credit bureaus. Over time, using your secured credit card responsibly can have a positive effect on your credit score.

Though most secured credit cards have annual fees, charge interest and don’t offer rewards, they can help you establish a firm financial footing as you practice good credit behaviors. They can also help ease the transition to a conventional credit card that has more flexibility with fees, interest and rewards.

Good credit practices

Whether you choose a secured credit card, a conventional credit card or a prepaid card, the best way to avoid debt and overspending is to learn and implement good credit practices:

Pay on time and in full: Missing a payment costs you not only in penalties and interest, but can also make it difficult to pay other debt obligations when you’re trying to catch up. The Nerds recommend always paying off your balance on time and in full each month.

Avoid spending too much: Even if you pay off your balance in full each month, having a high credit utilization ratio — your balance divided by your credit limit — can suggest you’re struggling to handle your current debt obligations. It is generally recommended to you keep your credit utilization ratio below 30%.

Keep a budget: A simple way to avoid spending more than you have is to maintain a monthly budget and track your spending. This will allow you to set limits on your spending and determine where you can improve.

Borrow responsibly: With each new loan payment, you lose the flexibility in your budget. Carefully consider how adding a new loan will affect your ability to pay basic expenses and other debts. Don’t be afraid to pay off one debt before adding another one.

The bottom line

Prepaid cards are becoming more popular because they promote concepts that are becoming increasingly important to millennials, including spending only what you have and staying out of debt. Prepaid cards, however, can come with a lot of fees, and users can miss out on an opportunity to build their credit and earn rewards. For those who want to build and maintain good credit, there are better options.

Ben Luthi is a staff writer covering personal finance for NerdWallet. Follow him on Twitter @benluthi and on Google+.

Image via iStock.