Credit or Debit? Your Choice Could Cost You 3%

By Michael Cramton
March 16, 2011

If you use a debit card on a regular basis, chances are you are constantly hearing the "credit or debit" question at the checkout counter. Since it's a debit card, shouldn't it be run as debit?

Actually, you have a choice in the matter: You can process the transaction as debit, requiring your personal identification number (PIN) to complete the process, or run it as credit and sign for the receipt.

Seems straightforward enough, right -- PIN or signature? But far away on Capitol Hill there is a war being waged regarding the fees banks charge for this service.

On one side there are the banks claiming the interchange fees, or "swipe fees," are necessary to cover the costs of processing the transactions and ensure fraud protection.

On the other side you have the merchants who claim they are increasingly losing their profits to the big banks' interchange fees.

The choice you make at the checkout is more than a personal matter -- it has a lasting impact on the small and large businesses you frequent. And as a consequence of this hidden fee structure, the prices you pay for the goods and services you need and enjoy may be going up.

Here's a closer look at what goes on behind the scenes of merchant transactions and how it affects swipe fees and the prices of everyday staples.

Credit or Debit

Purchases that are processed as debit, also known as an "online transaction" or “PIN-debit transaction,” are processed as an electronic funds transfer (EFT) through networks such as Star, Pulse, Interlink or NYCE. The processing deducts the money from your checking account almost immediately, as if you were making an ATM withdrawal. Online transactions require your PIN, and also allow you to receive cash back. Transactions processed as debit are the only option for getting cash back at the point of purchase.

Credit transactions, otherwise known as a "signature-debit transaction” or “offline transaction," do not require your PIN, and instead you're required to sign a receipt or digital keypad to complete the process. Credit transactions using your debit card are sent over one of the major credit card digital networks -- Visa, MasterCard, Discover, etc. -- depending on the network your bank is associated with.

Regardless of whether you choose credit or debit, you still have the same overdraft protection (if you've authorized that feature with your bank account); you still have the convenience of paying with a card rather than carrying cash; and you still have the convenience of not having to write a check.

But the difference in the hidden fees collected behind the scenes is causing an all-out battle between banks and retailers -- and driving up the costs of everyday necessities like food, gas and clothes.

Interchange Fees - The Cost of Doing Business

Interchange fees account for $20.5 billion in annual processing fees that merchants pay for the privilege of accepting plastic as payment.  The average swipe fee per transaction amounted to $0.44 in 2010.

For offline transactions using one of the major credit card networks (the "credit" option we mentioned earlier), the card-issuing bank or credit union works out a deal with one of the major credit card companies to use their processing service.

This fee amounts to around 2% - 3% of the total purchase price, which is paid by the merchant. This fee is then split up three ways: the majority goes to the card-issuing bank, a percentage is also paid to the credit card company and, lastly, a small portion is paid to the merchant's bank.

#-ad_banner_2-#Providers of online transactions, such as Star, Pulse, Interlink or NYCE, also work out agreements with banks and credit unions for the use of their electronic funds transfer networks. In contrast, though, these deals typically amount to an interchange fee of 1% of the total purchase price.

Of the two choices, merchants would prefer you choose the debit option because they keep a higher percentage of the transaction total. This is why when you swipe your debit card at Target (NYSE: TGT), Wal-Mart (NYSE: WMT) or Whole Foods (NASDAQ: WFM), the debit option is the first to appear onscreen. To run the transaction as credit, you have to select "cancel" or move on to a secondary screen for the credit option.

On the bank’s end, it's the swipe fee that pays for the rewards and cash-back offers they use as incentives to sign up for their cards. And they’re paying good advertising dollars to steer consumers into choosing the "credit" processing method.
 
Ultimately, an increase in debit fees means merchants will raise their prices to help cover swipe fees. This means that consumers will end up footing the bill, regardless of whether you pay by cash, credit card or debit card. In the end, you'll be paying yourself for those perks and gift cards you think you’re getting for free.

What it All Means for Consumers and Merchants

In July, 2010, Congress addressed this concern by passing into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. Included in the financial regulation bill was the Durbin Amendment addressing swipe fee reform, which gave the Federal Reserve the authority to limit debit card processing fees. One such proposal from the central bank suggested capping fees at $0.12 per transaction, a 73% reduction from its current average.

The Federal Reserve is ultimately responsible for writing the official banking rules for these reforms by April of 2011, and you can be sure that both banking lobbyists and merchant lobbyists are spending big dollars to get their way.

More and more, it appears that the Durbin Amendment, by trying to keep the price of consumer goods down, has ensured that prices for financial goods will go up as banks try to reclaim the loss of interchange fees.

If the swipe fee reform plays out as proposed, consumers can expect to pay higher fees for checking accounts and related services, like accessing checking histories and other online services. Consumers can also expect free checking accounts and debit rewards cards to quickly become a thing of the past. More alarmingly, to combat the fee cap, banks have threatened to place daily limits of $100 on debit transactions. For example, if you're accustomed to spending $100 or more at the grocery store, you may need to start thinking about alternative ways to complete your checkout.

But if banks and their customers are the losers in this war, merchants and their customers may be the winners. Merchants may start offering discounts depending on what brand of credit card you use (Discover card typically charges lower interchange fees) or based on your form of payment. If you're paying with cash you might expect up to a 3% discount on your purchase.

The Investing Answer: In the end, it's not certain how swipe reform will affect how we use and pay for debit card transactions. But the hidden fees that have been slowly driving up the costs of goods and services for the past decade have finally come into the light. Now it's up to the lawmakers to decide if big banking continues to benefit, or if the consumers and merchants can get a break from hidden interchange fees.

To learn more about interchange fees and swipe fee reform, visit these sites:
www.privacyrights.org
www.fightswipefees.com
www.nacsonline.com

Photo compliments of pongky.