Cards 101: A complete guide to prepaid cards

While prepaid cards may look like credit cards and are accepted at the same retailers, they're very different. In its simplest form, prepaid cards are a method of payment preloaded with money that you use to purchase things.

Let's take a look at the different flavors of prepaid cards and everything that you need to know about how they work.

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Key things to know about prepaid cards

The most important thing to know about prepaid cards is that they must be loaded with funds in advance. You can't spend beyond what you load and there is no credit score or credit history attached. Unlike a regular debit card, they are not tied to a bank account. Essentially, prepaid cards function similarly to gift cards.

According to the FDIC, in 2017 there were over 14 million Americans who didn't have a bank account. If you're one of these individuals or want to avoid traditional financial institutions, prepaid cards are an easy-to-obtain option requiring no credit check. Here are a few things to keep in mind about prepaid cards:

• Prepaid cards are marketed as an alternative to banks
• No credit required -- but no credit is built either
• Load money directly onto a prepaid card and then use that balance for purchases

How do prepaid cards work?

Prepaid cards function a lot like bank debit cards. They come with a PIN and in some cases you can accept direct deposits into your prepaid account. Unlike a conventional debit card, prepaid cards are not tied to a bank account and with some prepaid cards, you have the option to reload them back up.

You can even use some prepaid cards to withdraw cash from an ATM. However, there are fees attached to this functionality.

Types of prepaid cards

Open loop prepaid cards are branded with a network such as Visa, Mastercard, American Express or Discover. You're able to use these open loop cards anywhere the brand is accepted. If a retailer normally accepts a Visa credit card, for instance, you'll be able to use your Visa prepaid card there too.

Closed loop prepaid cards are only allowed to be used at specific merchants, such as at a particular store or group of stores. These are more commonly referred to as store gift cards and are brand specific. You can only use them at specified retailers.

Related reading: What credit cards should you use to purchase gift cards?

What are some advantages to prepaid cards?

There are a variety of reasons why someone might use prepaid cards as a form of payment. As mentioned, you don't need to have a credit history or a bank account to use prepaid cards. Some people may purchase prepaid cards to meet minimum spending requirements and use the balance to pay future expenses. Here are some advantages to using prepaid cards:

No prior credit history needed

Anybody can “qualify” to use a prepaid card, since you're not borrowing any money and there's no credit score that needs to be verified. This is particularly attractive for people with not-so-great credit, including any young people who have not yet built up their credit history.

No bank account needed

A prepaid card can be used in lieu of a checking account at a bank or credit union. If you don't have access to a bank account, a prepaid card still allows you to pay with plastic. For some prepaid cards, you can get some banking-like features like online bill pay, mobile checking, and ATM withdrawal.

Use it (almost) anywhere a credit card is accepted

Prepaid cards can be used anywhere a credit or debit card is accepted. That includes both online purchases and in-store. However, places like rental car agencies and hotels may not accept prepaid cards as a valid hold on the payment.

It could help with budgeting

Since prepaid cards have to be preloaded with funds, it can help you avoid temptations of overspending on money that you don't have. However, be cautious of common fees associated with prepaid cards. Some prepaid cards charge a monthly maintenance fee, for example.

Gift it as an alternative to cash

Prepaid cards can be gifted to a friend or loved one, but can also be used for yourself. While a gift card itself won't earn rewards, paying for it with a credit card that earns you a bonus will.

What are disadvantages to prepaid cards?

There are also disadvantages to prepaid cards that should be taken into consideration.

They usually come with fees attached

If you do decide to use a prepaid card, it's important to find out what fees you will have to pay and which card has the lowest one for your needs. While the Consumer Financial Protection Bureau (CFPB) requires prepaid card issuers to provide disclosures that clearly state fees, there are often many additional expenses (activation fees, usage fees, ATM fees, etc.) that could be avoided with other forms of payment.

If you need help building credit, consider other options

Perhaps the biggest disadvantage to prepaid cards is the inability to build any form of credit. While you won't need a credit check, the downside is that spending on prepaid cards is not tracked by credit bureaus.

There are usually fewer consumer protections

Some prepaid cards will restore the original balance and issue a new card if you report loss or theft of a registered card to the issuer. However, you will not have access to the same suite of protections in the way of fraud, unauthorized charges, warranty coverage, etc.

Related reading: Ways to use a credit card responsibly

Alternatives to prepaid cards

If you are looking to build credit, a prepaid card might not be your best option. Between the fees, lack of purchase protections and inability to build credit, a proper bank-issued debit card is a much better alternative if you qualify.

And if you are able to apply for one, secured credit cards can also help build credit. These particular cards require a security deposit from the cardholder when the account is opened. This security deposit is usually refundable and determines your initial credit limit. For those without credit history or with low credit scores, secured credit cards can be useful for building or repairing credit. You’ll initially want to make modest, occasional purchases on secured cards and focus on paying off a balance in full each month.

Bottom line

There are a variety of different types of prepaid cards in the market from issuers. It pays to know the pros and cons of each, as well as your financial goals, before using it. With this guide, you'll know what to look for -- and what to avoid -- when it comes to prepaid cards.