Financial Literacy Series:  Debit, Credit, or Cash?

November is Financial Literacy Month so I decided to write a series of posts explaining some key things everyone should know about their personal finances. These are things we should be learning in school. If you share this belief, please sign this petition which is a proposal to incorporate financial literacy into the Ontario grade 10 career studies course.

In Canada, there are 3 options when paying for something at a retail store:

• Debit
• Credit
• Cash

Let’s have a closer look at each one of these payment options and the impact they have on you and the retailer.

DEBIT

When you pay with debit at a store in Canada, what you are actually doing is using the Interac Direct Payment(IDP) network. Banks and retailers are connected to the IDP network.

Your debit card is issued by your bank and is connected to your chequing and/or savings accounts.

You have to type in your Personal Identification Number (PIN) on a point-of-sale(POS) machine at the retailer for anything over $100.

Under $100, most debit cards have a “tap” feature which utilizes radio frequency identification (RFID) technology to communicate wirelessly with the POS machine.

The money is then immediately taken out of your bank account and sent to the retailer’s merchant bank account.

Retailers can’t connect directly to the IDP network so they have to rent or buy the POS machine from their banks or other payment processors. Most banks have a merchant bank division but there are also many non-bank options as well.

The cost to you, the consumer, depends on your bank.

Personally I bank with Tangerine and I have no monthly fee and unlimited IDP transactions.

So my cost to use debit is zero.

Other banks will charge you a monthly account fee, say $10.95, and allow you unlimited IDP transactions. To calculate your cost per IDP transaction, simply divide your monthly account fee by the number of IDP transactions you make in a month, less the value of any other “free” bank services you use in the month.

The average cost to the retailer, in addition to the cost of renting or buying the POS machine(which can be $20-$40 per month), is around $0.06 per transaction. This very small flat fee is preferred by over 50% of Canadian retailers.

CREDIT

When you use a credit card you are actually borrowing money from your bank. This is an important concept to grasp before you even think about using a credit card.

Using your credit card to buy something from a retailer, is like taking out a tiny loan for a sandwich. You really want the sandwich now, and your bank is happy to loan you the money for the sandwich, hoping that you’ll take your time to pay them back.

Banks and retailers are connected via credit card transaction networks established by VISA, Mastercard and American Express, using the same POS machines as the IDP network, but in a slightly different way.

Like debit cards, you can “tap” the machine for any purchases under $100, but otherwise you will need a PIN, or have to sign your name on a receipt, to authorize the purchase.

After the transaction, the transaction shows up on your credit card statement, but you haven’t really paid any money yet. You did, however, sign a credit card agreement, agreeing to pay for anything that you buy with your card, so unfortunately you do have to pay for it eventually.

The bank pays the retailer’s merchant bank account, just like in a debit transaction.

The cost to you, the consumer, depends on you.

I make the majority of my purchases with my Tangerine Mastercard. It’s convenient(tap) and I get 1-2% cash back on every purchase I make.

Using my credit card for everything only makes sense if I pay it off before any interest is charged. Remember, it is a loan from the bank. But it’s a loan with terms that I like, and I control whether or not interest is charged.

The bank loans me money, up to my limit, with no interest for 21 days, and they pay me 1-2% cash for every transaction, depending on the category of purchase.

I pay no annual fee. Never get a credit card with an annual fee. That’s paying money to spend money.

What this means is that I’m actually benefiting from using my credit card – as long as I pay the full balance before the 21 days is up.

I always pay my balance within a week, sometimes less. But if you don’t intend to do the same, then DO NOT USE CREDIT CARDS AT ALL. Credit cards aren’t right for you. Just don’t do it.

You should only buy something with a credit card if you already have the money in the bank. If you buy something you can’t afford to pay for with cash right now, then you’ve already lost to the bank. You let the 21 days go by and now you’ve paid interest on that purchase.

Did you buy a $5,000 television, hoping that in the near future it would cost you $5,100? Of course you didn’t. But if you don’t pay off your credit card in 21 days, you will pay an extra $100 in interest, or more.

And every month that goes by, the TV costs you more and more. And you’re sitting at home, enjoying your TV, thinking you got a great Cyber Monday deal, not realizing that all of your savings are being consumed by credit card interest.

The cost to the retailer – is a lot more than debit.

It depends on the credit card you use, and the payment processor the retailer uses, but on average, the retailer pays 2% of all credit card purchases.

So your $5,000 television, which may have already been discounted by the retailer for Cyber Monday, cost them an additional $100 in credit card fees.

That’s not a small amount, when you consider that sometimes retailers can only afford to markup items 1-2% to stay competitive.

CASH

You would think that cash is the clear winner here, right?

No transaction fees for the consumer(unless your bank charges you to withdraw cash, then please, please, please, switch banks now).

No transaction fees for the retailer – they just take your cash and put it in the till. Well, not so fast there – unfortunately banks still charge businesses to deposit cash. It’s not a lot, around $2 per $1,000, but it’s not nothing.

From a transaction fee perspective, cash is the winner, but there are a whole bunch of other reasons why cash is not the best for the consumer or the retailer:

• Tracking: For the consumer and the retailer, debit and credit provide a benefit of tracking your purchases, so that you can review them later. Cash spent by consumers is often forgotten and then when you need to budget for groceries, you have nothing to work with, except faint memories of buying something, somewhere for some price. For retailers, debit and credit have systems for reconciliation and balancing, which cash does not
• Transaction Risk: Credit and debit transactions are controlled by user PINs and authorized POS machines, policies with limited liability for fraud, and systems for investigation of criminal activity. If you buy a Rolex watch for cash, start walking away, notice that it actually says Molex and is made out of recycled newspapers, you are pretty much screwed, because that person is long gone.
• General risk: if you lose your debit or credit card, you call the company to cancel your existing card and get a new one. If you lose cash, you’re screwed.
• Can’t rent a car or book a hotel room with cash: Not usually anyway. These places need trusted credit cards because they don’t know you. Even if you can give them a deposit in cash, do you really want to do that? They usually just need a credit card authorization, which costs you nothing. Giving someone a big wad of cash to hold for you is always a risk. They can decide to keep some of it because there is a little scratch on the car.

WHICH ONE IS BEST?

It depends on your personal philosophy and habits.

• If you think that transaction fees are a normal part of doing business for a retailer, then you probably don’t care much about the fact that retailers pay more for credit cards.
• If you can’t pay off your balance in 21 days – CREDIT CARDS ARE NOT FOR YOU. DON’T USE THEM. I’M NOT KIDDING.
• If you don’t care about tracking your spending and don’t feel at risk of losing your cash or being robbed, then cash will work for you.
• Maybe you never rent cars or book hotel rooms, or travel, so you don’t need a credit card.
• You may like that cash is anonymous and that the government can’t track it. That’s your choice and cash can help maintain your privacy.

You will ultimately come across situations where you will need all 3, or where paying with one is more convenient, or less of a hassle.

It should be noted that some retailers, like vendors in farmer’s markets, only accept cash, so having more than one option on hand can’t hurt for situations like that.

I was just in Kenya for a few weeks and there they use a mobile payment method called M-PESA. It is so widely used that often when I paid cash with the equivalent of a $10 bill, no one would have change for me. In Kenya, M-PESA makes sense because there is no debit, the credit card network is limited, and the risk of carrying cash is high. Meanwhile, everyone has a mobile phone.

The main point is that you should be aware of the implications of your chosen method of payment, whatever it may be, so you can make the choices that are right for the situation you are in, and also choices that align with your personal values and risk tolerance.