How a Bank views a Debit or Credit card Transaction

How a Bank views a Debit or Credit card Transaction

Most Americans are familiar with debit cards and credit cards. In fact, according to the Federal Reserve Bank of Boston, the average consumer has 2.7 cards in their possession. What is the difference between a credit or debit card? The terms "debit" and "credit" have specific basic meanings in accounting which we will explore, and then we will also look at how these transactions affect the banks' balance sheet.

In general conversations among people not familiar with accounting, it is assumed a "credit" is something good because it is synonymous with addition and a "debit" is something bad because it connotates subtraction. This misconception is not necessarily true because the terms "credit" and "debit" have specific meanings as they relate to accounting. The concept known as "double-entry bookkeeping" uses debits and credits to keep the accounts in balance. Debit simply means the left side of the account and credit means the right side of the account.

One of the basic equations of accounting is A=L+OE where A=Assets, L=Liabilities, and OE=Owners Equity. Whenever a debit is recorded, an equal credit must be recorded in another account to keep the Balance Sheet in balance. When a transaction takes place it is recorded in a ledger. The ledger could also be called a T account. Depending on if the account is and Asset, Liability, or Equity, the debit or credit will increase or decrease the value of the account. Asset accounts will typically have a debit balance. Additional debit transactions will increase an asset account value and a credit transaction will decrease the asset account value. For Liabilities and Owner Equity the opposite is true, debits will decrease the value of the account, credits will increase the value.

Let us look at a credit transaction first. If you make a $100 purchase using your credit card at a merchant, this transaction is considered an asset to the bank because they can expect payment from you in the future as an account receivable. They will debit the account receivable $100. To keep the equation A=L+OE in balance the bank will then credit another account on the liabilities side of the equation, something like accounts payable VISA, by the same amount $100

Now suppose you go into another merchant and purchase $100 worth of goods, and this time you elect to use a debit card from the same bank. Usually a debit card is linked to a personal savings or checking account. The bank considers these types of personal accounts a liability, because at the bank, you can make a withdrawal or use your debit card at any time and the bank must pay. When you use the debit card the bank will debit or reduce your account. Their liability to you is now $100 less. To keep the A=L+OE in balance the bank must now credit or reduce an Asset account. They could credit the Cash on Hand account to pay for the transaction.

Now that we have a little understanding of how a debit or credit transaction is handled from the banks' perspective, we must ask which card is the better choice to make a purchase. There are transaction fees being paid when you use your plastic card. The amounts and types of fees can vary depending on several factors including but not limited to the dollar volume a merchant turns. Debit card transactions can cost the merchant as little as $.25 each. To use a credit card for the same transaction a merchant will usually pay fees of 2-3.% Of course ultimately it is the consumer who is paying these fees, which on an aggregate add up to billions of dollars per year.

As you can see, it is in the merchants' interest for the debit card to be used at the point of sale. Some merchants may offer a discount for paying using debit instead of credit cards. Other merchants refuse to accept credit cards at all. Why are fees higher for credit transactions? One can assume with credit card transaction the bank assumes more risk. There is always a chance the customer will not pay back the bank. A debit card transaction is being funded with money you have previously deposited, so there is little to no risk for the bank.

This article is only a basic explanation of how the bank views different transactions. We have not taken into account credit card reward programs, or the amount of interest charged if your credit card bill is not paid off monthly, or overdraft fees if your debit card account falls below a minimum amount. These issues are worth exploration of the cardholder agreements and bank policies for the various types of cards you may be carriing.

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