05/16/2014 02:42 pm ET Updated Jul 16, 2014

Prepaid Debit Cards 101

As prepaid debit cards continue their rapid jump from the financial fringes to the mainstream, here are the basics on how they work:

If you are an obsessive viewer of classic TV shows like "Happy Days" or "Leave it to Beaver," it would be understandable if you thought that all American families were comprised of a mother, a father and a couple of precocious kids. But those of us who actually leave our houses long enough to look around at the real world know that such an idealized universe exists only on the TV screen. The same disconnect exists when it comes to overly simplistic assumptions about the financial situation in most American households.

Indeed, it is easy to assume that every American family has a conventional checking account linked to a debit card and keeps one or two high-limit credit cards -- that they pay off every month, of course -- around just for emergencies. But that idyllic notion is, well, old school. In fact, according to the U.S. Census Bureau just over one-third of American households might be able to do that. The rest of us rely on a mixture of financial products and tools to pay our bills and put food on the table.

For many families, prepaid debit cards have become an important and flexible tool for paying monthly bills and staying on a strict budget. It is true that the economic downturn of the past few years has damaged people's credit and made it impossible for many to obtain a traditional checking account or credit card. While that unfortunate reality has spurred the growth of prepaid debit cards -- U.S. News and World Report reports that $117 billion will go to fund prepaid cards in 2013 -- it's undeniable that these relatively new financial products are gaining traction among more mainstream consumers. With that in mind, it's helpful to understand a bit about how prepaid cards work and why they're gaining so much traction.

How Prepaid Debit Cards Work
While it's undeniable that many of the early adopters of prepaid debit cards sought them out as a result of sheer necessity, their ease of use certainly didn't hurt. In the most basic terms, here's how most cards work. Users fund their card -- or "load" them, in the vernacular of the prepaid card world -- with money via a direct deposit, wire transfer, PayPal or a variety of other means. And once the card is loaded, it works basically the same as a credit card, debit card or check. Cardholders can complete point-of-sale (POS) transactions, go online to shop, or get cash through ATM withdrawals. What is different from credit cards and debit cards linked to a checking account is that the users of prepaid cards cannot spend more money than what is loaded on the card. For families attempting to run cash only households, prepaid debit cards are helpful for staying on budget and out of debt.

Why Consumers Like Prepaid Debit Cards
In November of 2011, the Pew Health Group convened a series of focus groups to get a better handle on why so many people were choosing prepaid debit cards. One of the main reasons was fear of the unknown. In other words, researchers discovered that most participants felt burned by checking accounts that hit them with unexpected fees. While prepaid debit cards have fees -- and shoppers need to be very careful to understand those charges -- focus group participants found them to be more transparent than many checking fees. "They prefer the $2 and $3 fees from prepaid cards over the potential of a $35 overdraft fee on their checking accounts," the report said. Pew researchers also reported that "prepaid cards allow these consumers to limit their spending and avoid incurring unwanted debt," and "many regularly check their balance online or over the telephone." Some of the consumers said that they believed they had more financial privacy with prepaid cards and that the cards reduced the risk of identity theft.

How to Apply for a Prepaid Debit Card
First, shop carefully for the prepaid debit card with the fewest and lowest fees. Many card issuers have Web pages that detail their fee schedules so take the time to read how different offers compare. Be especially careful about monthly fees, charges levied to launch an account as well as fees for not using the card frequently enough, known as inactivity fees. Responding to consumers' complaints and legal challenges by various states' attorneys general, some prepaid card providers have minimized fees, and added fraud and theft protections. As more attention has been devoted to prepaid debit cards, issuers like American Express have also announced that their products will include protection by the Federal Deposit Insurance Corporation. Several credible websites, including this one, rank the best prepaid debit card providers and offer links to apply. Still, you absolutely must read the fine print very carefully before you hand over your cash.

But once you do choose a card, the process for getting one is simple. Prepaid debit card providers do not run credit checks on applicants. Therefore, "applications" serve primarily to verify customers' identities and basic personal information. Securing a major retailer's prepaid card takes just a few minutes and mostly involves trading cash for a card imprinted with the Visa or MasterCard logo. Reputable retailers will ask for some kind of government-issued photo identification, and most charge between $3 and $5 in setup fees. Once you activate a card, you may reload it, and you may use your card most places where you would use a credit or debit card. If you complete the process online, expect to spend approximately a minute completing the form, and about 15 seconds waiting for an acceptance. The card issuer then will mail your card, and you will pay about $5 to activate it. Loading procedures vary from card to card, but the providers encourage users to set up direct deposit with employers and benefits providers.

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