The Pitfalls of Prepaid Cards

Credit-card issuers are cracking down on cardholders, slashing their credit limits and even closing their accounts. As a result, many skittish consumers are turning to prepaid cards.

On the surface, prepaid cards seem like a "safer" way to spend. Backed by major issuers, such as Visa (V), MasterCard (MA) and Discover (DFS), these cards can be used just like regular credit cards -- with the exception that holders can only spend up to the amount they've deposited into their account. There's no risk of overcharging (and getting hit with an over-the-limit fee) or potential damage to a credit score since the cards don't represent a line of credit. In fact, parents have long turned to prepaid cards as a tool to teach teenagers how to spend responsibly.

But there are drawbacks to this convenient shopping option. Among them: hefty fees that can add up to hundreds of dollars if you're not careful. Here's what you need to know:

Prepaid cards may not come with the sky high late-payment fees or APRs of traditional credit cards, but they do carry a slew of other charges. “[Prepaid card issuers are] pretty creative with coming up with random fees,” says Curtis Arnold, founder of credit-card information site CardRatings.com. Cardholders can get hit with a fee when they activate their card, call customer support, withdraw money from an ATM, refill their card or order a replacement card.

To activate Visa's prepaid RushCard, issued by Manufacturers and Traders Trust Company, for example, you'll have to shell out $19.95. Lose your Green Dot MasterCard or Visa issued by Columbus Bank & Trust? That will be $10 to replace it. And if you want to put more money into your Account Now Visa card issued by Palm Desert National Bank, well, that will cost you $4.95.

“We encourage consumers to compare [these cards]. Read exactly how the fees work, and find a card that suits your specific needs,” says Jennifer Tramontana, spokeswoman for the Network Branded Prepaid Card Association, an industry trade group. (See our table for some of the better prepaid card deals currently being offered).

First, the good news: Prepaid cards come with the same zero liability loss protection that Visa or MasterCard-branded credit cards do, meaning your funds will be protected if the card is lost. However, the process to dispute charges for defective merchandise or unauthorized purchases is much harder to navigate with a prepaid card than it is with a credit card.

When you see a mistake on your monthly credit card bill, for example, you can withhold your payment. But with a prepaid card, you’ve already made the payment and now have to try to get the money back. So while you may get the same protections, it will take a lot longer to get reimbursed, explains Ben Woolsey, marketing and consumer research director at CreditCards.com.

You might find comfort in the AmEx or Visa logo on the face of the card, but what really counts is whether the issuing bank is FDIC-insured, says Arnold. The FDIC insures the deposits of more than 8,000 banks and financial institutions across the country. Should the bank that issued your card go under, the FDIC will reimburse you up to $250,000 per account (until Dec. 31, 2009, after which up to $100,000 in deposits will be covered).

To find out if your card is FDIC insured, check the issuing bank's web site, or the FDIC’s site.

Unlike credit cards, prepaid cards have no bearing on your credit score -- and that can be both a good and bad thing. “With a few exceptions, you’re not going to get reported to the credit bureaus [by using prepaid cards]", says Arnold. The problem is that while these cards can't harm your score, they also can't help it either. Regular credit card usage, paying bills on time and having a lengthy credit history all factor into a healthy credit score. But no matter how long you use that prepaid card, it just won't count.

There are plenty of prepaid cards out there for consumers to choose from. Here are a few whose fees are a little more palatable than others.