The Perils of Prepaid Debit Cards

Earlier this month, Justin Bieber joined the ranks of celebrities including Hilary Duff, Usher, Suze Orman, and Carmen Electra, who have endorsed prepaid debit cards. Banks have been using celebrity spokespeople to heavily promote prepaid cards in the past several years, particularly targeting the unbanked or people with credit issues. The Mercator Advisory Group estimates consumers loaded $82 billion onto prepaid cards in 2012. The Massachusetts-based advisory services firm projects that number will rise to $117 billion this year.

Despite the popular-culture appeal of prepaid debit cards, financial experts caution consumers that they are often riddled with fees for everything from activating the card to transferring money to using an ATM or automated phone system. John Ulzheimer, president of consumer education at SmartCredit.com, says the fees can vary but the net effect is essentially the same. "One may have a lower monthly fee but a higher ATM fee," he says. "It's almost like fee Whac-A-Mole. If you're not careful, it's like walking through a minefield."

Perhaps the most notorious example was the Kardashian Kard Prepaid Mastercard, which had a card purchase fee of $100 for 12 months and an $8 monthly fee. In response to backlash over the card's fee structure, the sisters pulled the plug less than a month after its launch in late 2010.

"These cards prey on the under- and unbanked, who mistakenly believe they're more economical than having a traditional checking account," says Mitchell Weiss, co-founder of the University of Hartford's Center for Personal Financial Responsibility and author of Life Happens: A Practical Guide to Personal Finance from College to Career.

[Read: A Prepaid Card for Recovering Addicts.]

Justin Bieber's new SpendSmart prepaid card--aimed at teenagers--charges a more modest monthly fee of $4. Still, that's $4 a month consumers can save if they pursue other options, such as opening a checking account. As Ulzheimer says, "The cost of a properly managed checking account is $0 a month, and the cost of a properly managed credit card with no annual fee is $0 a month."

Credit card expert and consumer advocate Beverly Harzog takes issue with the SpendSmart card's $3 inactivity fee if the card sits unused for 90 days. "That's so silly [to charge a fee] because you decided not to spend your own money," she says. However, inactivity fees aren't unique to the SpendSmart card. For instance, Western Union's prepaid card has no monthly fee but charges $3 after the card sits idle for 120 days.

The Credit CARD Act of 2009 regulates credit card fees but not prepaid cards. Harzog predicts the Consumer Financial Protection Bureau will take a closer look at prepaid cards in 2013 and perhaps regulate those fees as well.

On top of fees, experts warn that prepaid debt cards often fall short of their implicit--or in some cases, explicit--promises. One selling point is that prepaid cards help consumers avoid debt by capping their spending. "In my view, this perpetuates the problem by infantilizing consumers," says Weiss. "They are far better-served in the long run by taking responsibility for budgeting their spending with credit cards, even if that means directing the card company to limit your line of credit."

[Read: The Best Credit Cards for Rebuilding Your Credit Score.]

Another falsehood is that prepaid debit cards can help consumers rebuild their credit. "Credit agencies have gone on record as saying they don't include prepaid cards in their credit reports," says Ulzheimer. "A prepaid card is not a credit product. There's no due date, no late payments, no collections, nothing about a prepaid debit that's at all similar to a real extension of credit. It's almost like going to your local drugstore and buying a $50 iTunes gift card. This one has fees and that one doesn't. It's stored value on a piece of plastic."

And unlike traditional checking or savings accounts, prepaid cards are not insured by the Federal Deposit Insurance Corporation. "If the institution that issues that card goes under, the consumers lose all that money on that card," says Harzog. "So many people that use these cards are living month to month anyway."

However, Ulzheimer says prepaid debit cards can help a small market of consumers for a short period of time. Most consumers eventually want to build good credit history so they can qualify for a mortgage or a car loan, so a transition to traditional banking may make sense.

[Read: The 5 Best and Worst Prepaid Cards.]

For those consumers, secured credit cards (sometimes called prepaid credit cards) offer an alternative to prepaid debit cards. A secured credit card requires a deposit similar to a security deposit on an apartment lease, and the cardholder gets a bill each month similar to a regular credit card. Once you eventually get promoted to an unsecured card or boost your credit score enough that you can apply for an unsecured card elsewhere, you typically get that deposit back, adds Harzog.

Credit cards also offer consumer protections that debit cards don't, as Ulzheimer points out. If, for example, you get billed for something you didn't order or that never got delivered, you could dispute it and the charge would be removed from your bill in accordance with the Fair Credit Billing Act. Debit cards do not offer these same chargeback rights.