How debit cards stack up

It isn’t known for granting rewards points, and it won’t build a credit score. It even has a higher incidence of fraud and nearly collapsed entirely in the early 2010s. But now, it turns out that the humble debit card is the number-one preferred payment method in America, far outpacing cash, credit, and checks—former stalwarts of American transactions that paved the way for the emergence of debit in the first place.

Debit cards didn’t emerge in a vacuum, however. Their evolution is inextricable from that of ATMs, which provided the necessary infrastructure, and credit card networks, which drove debit into the mainstream.

The origins
The first debit card came about at the Bank of Delaware in 1966 and was followed by other pilot programs at regional banks. At the time, these banks wanted to provide a way to make transactions and transfer cash that was easier and faster than credit cards, though the pilots still required customers’ signatures and withdrew the funds from their accounts with a delay.

While a credit card effectively extends a loan to the consumer that has to be repaid to the bank, a debit card functions more like a check, allowing a merchant to draw funds directly from a customer’s bank account. Payment, then, is pretty much guaranteed and near-immediate.

While credit cards were, by the late sixties, largely operated by card networks like Visa and MasterCard (a fate that would soon come for debit, too), debit cards were still the domains of banks themselves, granting them greater control over their customers’ spending habits. But early debit cards had a limited range and could not be used outside the city in which their bank was located. They needed infrastructure to make them more widespread.

Enter the ATM. These machines were invented by banks to provide customers with certain essential services even when the bank was closed, especially because banks could not afford to stay staffed around the clock. One of the earliest modern ATMs was installed at New York’s Chemical Bank in 1969. Though it was the first to move away from paper vouchers and require a magnetic stripe card for access, its technology was still rather primitive. In 1972, a bank in Cleveland successfully installed an ATM that could be accessed with an ATM-only card (rather than a credit card). Soon, banks began installing ATMs away from their branches, which was enormously cost-effective: Instead of building $1 million bank branches, they could simply install 24-hour ATMs at strategic locations for a fraction of the cost. ATMs began spreading into gas stations, grocery stores, and other places where savvy proprietors realized that easy access to cash encouraged customers to come in and spend more.

In the 1970s and 1980s, banks realized they could share their ATMs with each other and charge other banks’ customers for using their machines. It was a win-win, as banks were making money and customers were gaining ever-easier access to cash. Banks joined together to form shared regional networks. These networks then joined together to create shared national networks, granting customers access to ATMs all across the United States. The largest of these networks, Cirrus, was formed in 1982 by joining regional networks from 10 major cities including Boston, Chicago, New York, and Pittsburgh. By 1985, Cirrus was operating ATMs in 46 states with more than 6,500 ATMs. Plus and Master Teller were the other leading shared national networks at the time.

In 1976, two grocery store chains in Massachusetts with ATMs went a step further and installed the first in-store point-of-sale debit systems. This allowed customers to use their ATM cards to pay for purchases with debit while providing further advantages for the store: there were fewer checks to process, less opportunity for bad checks, and less cash on hand to attract robbers. But because transaction fees and the installation of POS terminals were extra expenses that most merchants weren’t willing to take on, widespread debit card use stalled until the mid-1990s—even though, by this time, ATMs were ubiquitous. People could get cash easily, but using debit cards to make purchases was still very new.

Crowning the debit card kings

Then came a major breakthrough. Big credit card networks had long been eyeing the debit card business, which they knew could provide a sizable source of income. Owning a wide swath of the country’s ATMs would be an in. In 1986, Visa bought the Plus network, which nearly doubled the number of ATMs Visa owned to more than 33,000. The same year, MasterCard—which owned the floundering Master Teller national ATM network and was looking to expand—made a $28 million bid to acquire Cirrus, which the network rejected. A year later, MasterCard tried again with $38 million, which was accepted, and promised 35,000 Cirrus ATMs within two years and more than 116 million cardholders.

The two card companies’ acquisitions led to greater efforts to get more customers on board with debit and credit cards.The companies also seized the opportunity to make money on fees from merchants and customers who overdrew their accounts. The two behemoths also struck a deal to allow owners of one company’s ATM to provide services to the other’s cardholders.

With that, they pretty much shut out competition. The two companies continue to dominate today’s debit card market: Visa had 471 million debit cards in circulation in the U.S. in 2015 and MasterCard had 183 million. In 2013, Visa and MasterCard debit cards together contributed to 93 percent of global debit transactions. Visa debit cards made up 38 percent of all card-based transactions, including credit cards, across card companies globally.

By the 1990s, the number of POS terminals was growing, as both merchants and banks wanted easier and faster payment methods. By 1993, 700 million transactions were made using debit cards in the U.S., and 1 billion by 1994. (At this point, though gaining, the technology was still fairly new. 1994 also saw 14 billion credit card transactions and 62 billion payments by check.)

By the turn of the millennium, debit was dominant in the United States: There were 8.3 billion transactions in 2000. In 2012, there were 47 billion. In 2015, Visa and MasterCard alone were responsible for nearly 50 billion transactions.The average debit card user is now using their debit card more frequently and spending more money with it every year.

How a debit card works—and how it almost broke the system

Despite being touted for their ease of use, debit cards are surprisingly complicated. After swiping a debit card at a retailer, the consumer still has to select whether the card should be processed as debit or credit—which is actually the difference between an “online” or “offline” debit transaction. It has very little impact on the customer, but can be a big deal to the merchant and the bank, for whom it’s all about the fees.

It turns on the two ways for customers to verify their purchases: either by entering a PIN or signing for the transaction.

When a debit card transaction is run as “debit,” the customer is asked to enter a PIN. From there, the transaction runs through the debit card network and verifies the funds are available, and the money is deducted from the customer’s account instantly.

When a transaction is run as “credit,” on the other hand, the customer signs a receipt, and the available funds are not checked—thereby bypassing the network, hence being “offline.” The transaction is held, often until the end of the day, when the funds are deducted from the account. In essence, it functions like a credit card transaction or a mini-loan, but the funds are deducted from the customer’s account within several hours. This can be a headache for the merchant, and those fees, which are similar to credit card fees, can sometimes get passed on to the customer. On the other hand, this kind of transaction, like with credit cards, can be safer, and some banks will offer better anti-fraud protection for it.

The fee schedules for these two methods are complex, and depend on the size of the card-issuing bank (bigger banks pay a smaller, regulated fee) and the size and volume of transactions. PIN-based transactions have higher transaction-based fees and lower percentage-based fees, while the opposite is true for signature-based transactions.

Around 2010, card networks realized they could manipulate these fees and drive them up exorbitantly, which benefited banks and networks, but hurt merchants (and, if the fees got passed on, consumers). At the time, customers signing for debit purchases cost merchants nearly twice as much as having them punch in their PINs, and some major retailers like Costco and Wal-Mart eliminated the signature option altogether in order to avoid major losses.

In response, new federal regulations capped the interchange fees in 2011, lowering them in some cases by nearly a third. Predictions abounded that the fee regulations would be debit’s death knell, because it was no longer profitable to banks and card networks.

Debit’s resurgence

In response to the new fee regulations, however, banks actually began marketing debit cards even more aggressively, hoping to make up in volume what they were losing in revenue. They incentivized their use by soon reintroducing debit rewards programs, which had been abruptly cut off when the new fees were expected to cost banks millions of dollars. Instead of functioning like credit card rewards, which allow a customer to accumulate points to cash in, the new debit rewards system gives customers discounts at retailers they visit frequently. Banks also market debit as an easy way to make quick, small, everyday purchases. (They get the same interchange fee for every transaction, large or small, so using debit for your daily cup of coffee gets them the same profit as the purchase of a computer.) What’s more, they’re marketing debit online, where much of their target market—millennials—is likely to be receptive.

According to a TSYS study, most people who use debit cards now say they like them because of the instant movement of money from their bank accounts (as opposed to the two-to-three–day delay a credit card transaction requires). What’s more, the ability to get cash, either at an ATM or through cash back, is a major motivating factor.

A study by Chime also found that consumers, especially young ones, also like the confidence that they’re spending their own money—money they know they have—as opposed to racking up debt on a credit card. This might just be post-recession anxiety that can likely be solved with budgeting skills, but it makes millennials the ideal debit customers. More than two-thirds of millennials say they prefer debit cards to credit cards, largely because of a fear of mismanaging money and because of an aversion to debt brought on by the generation’s vast student loan debt.

And that’s despite the risks. It turns out that 35 percent of Americans are afraid of debit card fraud, according to a 2014 study by Aite Group. And with good reason: In 2012, there were nearly 15 million instances of fraud on debit cards, as opposed to only 13.7 million on credit cards.

Yet despite these threats and against all odds, debit cards have risen to the top. With new rewards programs enticing new customers and ease-of-use retaining existing ones, debit cards’ popularity only continues to grow. Yet as it does so, it remains to be seen how this payment method will continue to affect merchants and banks, and whether it will reach another tipping point anytime soon.