Prepaid cards: how they work


internet shopping card

On the high street, a prepaid card is indistinguishable from any credit or debit card.

They can be used wherever the issuer - Visa, Mastercard or Maestro - is accepted, and they work with chip and PIN, or for online transactions.

There's one big difference, however.

How prepaid cards work

Unlike credit cards which explicitly loan us the money until we pay it back, and even debit cards that "borrow" the money until it can be drawn from our current account, a prepaid card must be loaded with money first and we can only spend what we've loaded it with.

Cardholders can usually top up via bank transfer, with a debit or credit card, at a post office or with a participating retailer.

Most prepaid card providers make money by asking cardholders to pay for those various methods of loading money on to the cards.

Alternatively, or sometimes in addition, they take a fee when the cardholder uses the card for spending or to take out cash. Some prepaid cards charge fewer fees and instead ask for a flat monthly fee for holding the account.

Why get a prepaid card?

Loading is a pain and paying can certainly be painful compared to free to use debit cards. So why go prepaid?

Safety

Not having a credit facility makes prepaid cards a safer way to spend.

Cardholders can set money aside for particular uses - spending at the sales, for example - and because they've limited themselves to a certain amount beforehand, they can't give in to the temptation to splurge.

For that reason, and since they're accepted worldwide, prepaid cards can also be particularly good for holiday spending.

Proponents also claim that they can shield consumers from losing large amounts of money as a result of online fraud. Kevin Harrington, the then MD of the Global Prepaid Exchange had this to say after the PlayStation network hack in early 2011:

"While there is probably nothing gamers could have done to prevent the hackers accessing their details, they could have protected their finances by using a prepaid card instead of a credit card to make online transactions."

Another safeguard against loss was introduced in May 2011 when rules regarding electronic money made it more difficult for providers to refuse to refund cash loaded on to a card.

Poor history options

Because prepaid cards are not a form of borrowing, there are no credit checks involved in applying for one.

For that reason they're popular with some consumers who have a very poor credit history, including bankrupts.

However, as we'll see, prepaid cards always charge fees for basic transactions and lack some forms of consumer protection.

It's worth noting, then, that all basic bank accounts must now provide a free to use payment card, usually in the form of a debit card.

Nevertheless, some prepaid cards remain a good option for those with poor credit either where basic bank accounts aren't available, or as a way of helping to build or repair credit history.

Credit builder cards work by treating the holding fee like a very small loan; paying for the card each month appears as positively repaid borrowing on a credit report.

Under-16 card options

Some cards have minimal age restrictions, with some specially designed for children and teenagers: we know of a couple that are available for children as young as eight.

In these cases providers only offer prepaid cards to younger users when the main account is managed by someone aged 18 or over, such as a parent or guardian.

Other prepaid card issuers provide additional cards for those aged 13 or over, again on the condition that the main card and account are registered to someone aged at least 18.

Prepaid cards can be seen as a way to teach youngsters how to manage their money effectively, and they're safer than carrying cash.

There's also a strong case to be made for allowing teenagers to have a secondary card that doesn't have a credit option, in case of emergencies.

Rewards

Odd as it may sound, some prepaid cards offer rewards in the form of cash back, just like some debit and credit cards.

The cash back is usually restricted to particular high street retailers, and any potential earnings must be balanced against the cost of having the card, which can vary greatly (see below).

Fees and charges

As we noted above, prepaid providers aren't issuing cards out of the kindness of their hearts.

Here's a selection of some of the fees to look out for:

Monthly fees and initial fees are applicable to some accounts. Others charge low standard fees but will cost users heavily if they top up in a different way or use them abroad.

Pay monthly

For the first type, cardholders pay a monthly fee for using the card, typically around the £5 mark. In most cases, they then pay no fees on purchases made in the UK - there's usually a foreign transaction fee.

The best way to see what we mean is to look at some real world examples, so here are two pay monthly cards and their fees, as correct at the byline date:

Pay as you go

With PAYG prepaid cards there's no monthly fee, but cardholders usually pay a fee for purchases and other transactions made with the card.

These fees can range from less than £1 to around 2.95% of the value of the transaction, and additional charges may be added on top for purchases outside of the UK as well as ATM withdrawals.

Here's one example of the kind of charges we can expect with a pay as you go prepaid card, accurate at the byline date:

Low standard fees

In recent years more prepaid card providers have appeared on the scene, which has helped make the cards that bit more competitive.

However, while some of these cards charge attractively low standard fees, there are high charges to be aware of. Here are two such cards:

Foreign use cards

Designed especially for use abroad, as mentioned above these prepaid cards often charge preferential fees when used for transactions in their designated currency. While they can be used in other locations or to make payments in other currencies, they'll be subject to higher fees.

Here are a couple of typical foreign use prepaid cards as an example:

Problems with prepaid

It's clear that fees may be one problem with prepaid cards, when compared with other ways of paying.

Similarly, card holders may have fewer rights when using a prepaid card than they would with a debit or credit card issued by a mainstream bank.

No FSCS protection

For example, many users don't realise that the money stored on these cards is not protected by the Financial Services Compensation Scheme (FSCS); there's more on this here.

The FSCS ensure compensation of up to £85,000 in case of an emergency, such as the collapse of a financial provider.

However, in the case of prepaid and e-payment cards, should the provider become insolvent any funds loaded onto the card are not protected. They'll disappear.

"Before taking out any products, consumers should ensure they should visit our website or ask the provider about FSCS protection," Mark Neale, chief executive of the FSCS has said.

As many prepaid card users only load them up with relatively small amounts at a time, FSCS protection should really only worry regular prepaid users with large balances on their cards - a minority of cardholders.

It's interesting to note that those with smaller balances are actually more protected: under EU law, very small balances on prepaid cards, too small to use if the card provider insists on a minimum transaction value, must now be returned to cardholders.

No section 75

Since prepaid cards aren't a form of borrowing, consumers aren't protected under section 75 of the Consumer Credit Act.

The closest thing prepaid cards have to section 75 is protection on purchases with the CashPlus Prepaid card (more details) which, the card provider says, is extremely similar.

However, protection is provided at the discretion of CashPlus, so it's not the same as the solid legal protection offered under section 75.

Do note that when a prepaid card is issued by MasterCard or Visa cardholders may be able to make a claim under the issuer's chargeback scheme.

Again, though, this protection is nowhere near as strong as section 75: see this article for a full explanation.

No help with debts

As we noted above, prepaid cards are also often used by those with poor credit histories.

There's no risk of running into debt with a prepaid card as it has no credit or overdraft facility and crucially, isn't connected to any personal bank details.

Yet that also means that, unlike banks and building societies, prepaid card providers have no obligation to help people who are struggling with serious debts or on a very low income.

For example, in January 2010, MPs spoke out against prepaid firms targeting benefits claimants and eating into the state aid significantly in the form of charges for use.

Safety

For users, as we've said above, prepaid cards are actually very safe: we can't spend more than we have loaded on there.

From a provider or Government perspective, however, prepaid is actually less safe.

The fact that prepaid cards are available without a credit check, and often without any more confirmation of our identity than a valid postal address, means that they're attractive to those involved in money laundering or who wish to buy things online without leaving a paper trail.

With this in mind it'll be interesting to see how these products evolve in the next few years, we'll be watching.