Credit to Debit: Should You Make the Switch?

In early October, Bank of America (BAC) notified some of its credit-card customers that it would be introducing experimental annual fees of anywhere between $29 and $99. That came on the heels of Citigroup’s (C) August announcement that “a small number” of customers would see changes to their account, including a new annual fee.

With two of the largest card issuers making the leap, it is only a matter of time until other banks introduce some form of an annual fee themselves, says Curtis Arnold, the founder of CardRatings.com, a credit-card comparison site. “It’s a monkey see, monkey do industry,” he says. “When one major issuer does a major policy change, the others are likely to follow suit because they’re all desperate for revenue.”

Already credit cards are getting more expensive for everyone: Between December 2008 and July 2009, the lowest advertised annual percentage rates (APRs) for purchases on credit cards increased from 9.99% to 12.24%: a 23% jump, according to a recent report by The Pew Charitable Trusts, a nonprofit organization. (The highest-advertised rates jumped from 15.99% to 17.99%.)

For consumers getting hit with new fees or higher rates, switching from credit to debit would seem the natural next step. And that’s what many seem to be doing, according to the latest statistics on the dollar-amount charged to Visa and MasterCard credit cards compared with that for debit cards.

In the first half of this year, consumer charges on Visa (V) debit cards were up 6% compared with the same period in 2008, while the amount charged on credit cards declined 15%, according to payment-card data tracker CardData.com. MasterCard (MA) debit-card charges were up 4% compared with a 19% decline for credit cards.

Even though debit-card usage has been growing for years at the expense of cash and checks, this shifting preference from credit to debit is a recent one. It correlates with card issuers reducing credit limits, hiking interest rates or closing out credit accounts altogether, says Greg McBride, a senior financial analyst for Bankrate.com. “It’s just lack of options,” he says. “If your credit line is cut or your card is closed altogether, it severely limits your ability to use the credit card, no matter how much you want to.”

But locking up your credit cards in a drawer – or closing them altogether – can be a big mistake, unless you do it strategically. Given the shifting landscape of credit and debit, now is an opportune time to develop a strategy. Here’s what you need to know.

You may be so mad at your credit-card issuer for hiking your interest rates or lowering your credit limit, that you vouch to pay off the balance and close the account as soon as you possibly can. (That will show them, right?)

Don’t do it. Closing a credit card will automatically increase the amount of total available credit you are using, which will hurt your credit score, says John Ulzheimer, the president of consumer education for Credit.com, an advocacy group. It’s a matter of simple mathematics. Say you had three cards with an aggregate limit of $30,000 and an aggregate balance of $15,000. Your current utilization (which determines 30% of your credit score) is 50%. But if you close a card with a $10,000 limit, your credit utilization jumps to 75%. “Even if you don’t use your credit cards, keep them open,” Ulzheimer says. “At the very least, because you never know when you’re going to need them again.”

If you find yourself having to pay annual fees on credit cards you’re not using, closing one or more of those cards may be worth the savings. To preserve your credit score, however, you may want to apply for new credit cards (that don’t have annual fees), so in effect you will replace a card’s available credit limit before closing it. Your score will take a small hit because you’ve got a new inquiry and credit account, but the effect will be temporary – and may be worth it if it saves you from paying hundreds of dollars in annual fees, Ulzheimer says.

(A caveat: Keeping a bunch of credit cards with $0 balances is great for your credit score, but the longer a card is inactive, the higher the likelihood that the issuer closes it for inactivity, Ulzheimer says. To avoid that, consider using your credit cards for small purchases every couple of months.)

Another reason to hold onto your credit cards: Traveling can be a lot more stressful when you use a debit card. That’s because certain merchants – hotels, car-rental companies and even gas stations – tend to put a hold on funds before approving a transaction, says Linda Sherry, a spokesman for consumer advocacy group Consumer Action. So when you check into a hotel or rent a car, the hotel or car-rental company will freeze a certain amount to ensure the money is available for that transaction to go through. If you are using a debit card, which is linked to your checking account, you'll be unable to access that cash for days or weeks. On a recent business trip, for example, Sherry had $1,200 of her credit-card limit blocked for a three-night hotel stay that cost only $129 a night. “If that’s your debit card, you don’t want to be out $1,200,” she says.

Worse, some rental companies may check your credit if you use a debit instead of a credit card. A recent survey of 45 car-rental locations by CreditCards.com found that more than half (24) required an additional deposit of anywhere between $100 and $500, until the car was returned. Some locations -- 10 of those surveyed – did a credit check, which creates an inquiry on your credit report and a temporary hit on your credit score.

Signing for a debit-card transaction (as opposed to using a PIN) will generally grant you the same consumer protections as using a credit card, including $0 liability for fraudulent purchases and credit-card perks like extended warranty and purchase protection. But there is still one caveat: Should your credit card (or credit card number) be stolen and used to fund a shopping spree, your own money – in your checking or savings account – is on the line. Banks are required to provide a provisional credit within five days while investigating the case, but in the meantime, you may be short on cash and incur overdraft fees, says Sherry.

Sure, credit cards may expose you to all kinds of traps, from hiking your rates to slapping on new fees. But using a debit card isn’t exactly a walk in the park, either. In fact, debit cards pose a whole host of traps themselves, chief among them the danger of overdrawing your checking account. According to a recent report by the Center for Responsible Lending, more than 50 million Americans overdrew their checking account at least once in 2008, with 27 million incurring five or more overdrafts. The cost of doing so can add up quickly. Despite recent changes to the overdraft policies of two large banks (Bank of America and JP Morgan Chase (JPM)), overdraft fees remain high, an average $34. In 2008, banks and credit unions collected nearly $24 billion in overdraft fees, a 35% increase since 2006. For more details on overdraft programs and other risks of using a debit card, click here.