How Do Prepaid Credit Cards Work?

If you have bad credit or want to avoid using traditional credit or debit cards, you might consider getting a prepaid credit card. Prepaid cards are easy to obtain and require no credit check. You can use prepaid cards online or when you can't pay in cash, but they won't help your credit score.

"Prepaid cards can be purchased at banks, discount (stores) and convenience stores," says Mike Sullivan, personal finance consultant with Phoenix-based Take Charge America, a nonprofit credit counseling and debt management agency. "They can be obtained quickly and cheaply."

What Is a Prepaid Credit Card?

Prepaid cards are different from traditional credit cards, even though they might carry the Visa, Mastercard, Discover or American Express logos. Rather than tap a line of credit, prepaid card users spend only what they load onto the card.

How do prepaid cards work? Prepaid cards actually work a lot like bank debit cards. Each transaction reduces your cash balance, but unlike a conventional debit card, a prepaid card is not tied to a bank account. You can use some prepaid cards to withdraw cash from an ATM, but you can only withdraw up to the amount loaded onto the card.

Some prepaid cards are reloadable -- meaning you can add money to the card multiple times -- while others are not.

"You actually are spending your money," says Paul Golden, director with the National Endowment for Financial Education in Denver. "This is not money that's being lent to you like with a credit card."

[Read: Best Credit Cards for Bad Credit.]

Compared with traditional credit cards, prepaid cards can make it harder to go into debt because many prepaid cards will not authorize purchases that exceed the amount loaded on them. Those that do allow you to go over your limit may charge an overdraft fee, although new federal rules limit these fees. Keep in mind that you can go over your limit if you have a low balance and a separate card fee puts you in the red.

Different Types of Prepaid Credit Cards

Prepaid cards fall into two major categories:

Open loop. This type of prepaid card is branded with the logo of a network, such as Visa, Mastercard, American Express or Discover. You can use these cards anywhere the brand is accepted.

Closed loop. You can only use this type of prepaid card in specific places, such as at a particular store or group of stores.

Employers may issue reloadable open-loop cards to employees to provide pay and benefits more easily. "Some employers even offer the option of having payroll delivered to unbanked employees via prepaid cards," Sullivan says. These are also known as payroll cards.

Government agencies also may use open-loop cards to pay benefits , such as unemployment insurance.

The Pros of Prepaid Credit Cards

You can use the cards to put the brakes on spending. Prepaid cards can be a great tool for consumers who struggle to live within their financial means. "Prepaid cards are useful in helping control spending and managing expenses," Golden says. You can use them to set a budget for particular expenses that you may be more likely to stick to than with a bank or credit card account.

No approval is required. The cards make sense for consumers with poor credit who can't get approved for a credit card. "There's no credit check to get a prepaid card," Golden says.

The cards are more secure than cash. Prepaid cards offer a way to access money without carrying around a wallet full of bills. In April, rules from the Consumer Financial Protection Bureau went into effect that give prepaid cardholders some of the same protections that debit cardholders have.

Now, consumers who report that their cards are lost, stolen or fraudulently used in a timely way are entitled to a company investigation of their claim, reimbursement for unauthorized charges and correction of errors. The new rules apply to prepaid accounts, which range from prepaid plastic cards to money in mobile and internet-based accounts.

To ensure that you have these protections, you must register the prepaid card, either when you purchase it or later online or by phone.

The cards make great teaching tools. One of the most overlooked benefits of prepaid cards is that you can use them to teach children how to manage their money. "It can be an effective tool to get younger kids interacting with plastic," Golden says.

It's an easy way to give money. Prepaid cards can make excellent gifts, Sullivan says. Unlike store-branded gift cards, open-loop prepaid cards can be used anywhere the network's cards are accepted, making them a more flexible option than traditional gift cards.

The Cons of Prepaid Credit Cards

While prepaid cards have perks, they also have a few drawbacks.

If you don't register your card, you may be limited in how you can use it. Before using a preloaded card, you may be required to register it with the card provider to access all of its features. If you fail to do so, you may not be able to add more money to it, use it online or withdraw funds from an ATM, for example.

You might pay fees to use the card. "Prepaid cards are not perfect," Sullivan says. "There is a cost to buy them, and there can be expenses involved in using them."

Among other costs, you might pay:

-- Fees for each purchase

-- Inactivity fees

-- Fees to reload or replace the card

-- Activation fees

-- ATM fees for transactions or balance inquiries

-- Customer service inquiry fees

-- Overdraft fees

[Read: Best Starter Credit Cards.]

Sullivan notes that "the most predatory cards" may charge a monthly fee simply for keeping the card active.

Prepaid cards do not report to the credit bureaus. As a result, they do not allow you to build a credit history. Prepaid cards won't help you establish or repair credit, except as a tool to control spending.

The cards aren't always accepted. Prepaid cards typically are accepted wherever credit cards can be used. But Golden says you might run into challenges if you try to rent a car or reserve a hotel room with a prepaid card. Rental car companies or hotels may ask you for a cash deposit or place a hold on prepaid card funds.

You may only be able to spend what's loaded on the card. While some prepaid cards allow overdrafts, others do not offer any way to make a payment if your expense exceeds what is on the card. "If the card does not have enough value for a transaction, the transaction will be denied," Sullivan says.

The cards come with limited consumer protections and benefits. Credit cards may offer cardholder benefits and account protections, such as zero liability for unauthorized charges, extended warranty coverage or travel insurance. Prepaid cards don't offer the same level of benefits or protection.

Can you use prepaid credit cards online? Yes. Most of these cards are branded with a network logo -- such as Visa, Mastercard, American Express or Discover. These cards can be used anywhere the brand is accepted, including for online shopping.

While prepaid cards offer the same protections as debit cards, these are more modest than the protections you get when using credit cards. For this reason, experts generally recommend using credit cards when transacting online.

They provide less rewards potential. Prepaid cards may not offer rewards, and if they do, they're usually at lower rates than credit cards.

Choosing the Right Prepaid Credit Card

Read the agreement that comes with your prepaid card to make sure you understand the card's limits and fees.

"Prepaid cards are not created equal," Sullivan says. "Buyers must be careful when selecting a card."

The CFPB requires prepaid card issuers to provide disclosure forms that clearly state the fees. Fee schedules must be made available on the company's website and can be found on the CFPB website.

Some fees are especially worth avoiding, Golden says. He cites cash withdrawal fees and monthly service fees as being particularly egregious. "It's up to the consumer to really understand where all the fees are assessed and if you're able to avoid those fees," he says. "And if not, then that's probably not the right product for you."

The funds attached to some prepaid cards are insured by the Federal Deposit Insurance Corp., but not all prepaid cards are covered, and some may have requirements such as registering the card. If such coverage is important to you, call the issuer to inquire about it before purchasing a card.

Also, some cards can be used outside the U.S. Others cannot, or the card will charge foreign transaction fees when used outside the country.

Alternatives to Prepaid Credit Cards

Although prepaid cards might make sense for some consumers, other options could be a better fit, including:

-- Secured credit cards

-- Cash

-- Money orders

-- Debit cards

[Read: Best Secured Credit Cards.]

Because prepaid cards do not have a line of credit attached to them -- and because your spending activity with them is not reported to credit reporting agencies -- they will not boost your credit score.

Consumers hoping to build or rebuild a credit history might be better off with a secured card. This type of card allows you to make a deposit with a credit card issuer in a specific amount that acts as collateral. Your credit limit is typically the amount you've deposited. The deposit isn't used to pay your bill. You'll be required to pay back what you owe with at least a minimum payment each statement period.

Your security deposit lowers the risk for the issuer and makes getting approved for the card easier for you, even if you don't have good credit. Secured credit cards typically report your account activity, including payments, to the credit bureaus. Regularly paying your secured credit card bill on time can help you build a positive credit history.

"Where a prepaid card is not going to help you build a credit history, a secured card may," Golden says.

But with secured cards, the upfront expense can be a problem. While you can typically purchase a prepaid card for less than $5, secured credit card deposits range from $200 to $500.

Nevertheless, a secured card can be a powerful tool for getting your financial life moving in the right direction. Once you've established a good payment history with a secured credit card, you may get a credit limit increase, which might require a larger security deposit, or an upgrade to an unsecured credit card and your security deposit returned.

Other alternatives to prepaid cards include cash, money orders and a debit card. A traditional debit card is one of the best alternatives to prepaid cards, Golden says. However, getting a debit card requires having a relationship with a bank.

"There are a lot of people who use prepaid cards who want to avoid banks for whatever reason," Golden says. "Maybe they were hit with overdraft fees and a lot of other fees, and they just ended up closing their account rather than put up with it anymore."

Golden says he understands that some people are reluctant to take that step if they have had a negative banking experience in the past. But some comparison shopping can help you find a bank with low fees and the customer service you need, he says.

In the end, knowing yourself and your needs is the best way to determine whether prepaid cards are right for you.

"It all comes back to shopping around and doing your homework," Golden says. "First, map out what your goals are. That's going to help you decide which product is right for you."