Credit cards, debit cards, and cash–which way of paying is best?

At a bar, I once saw three people at a table receive separate checks, and amazingly, each of them paid in a different method. The first person threw down cash, the second a debit card, and the third a credit card. It got me thinking about why people pay in different ways. I typically use a high cash reward credit card, but depending on your preferences and discipline, you may see advantages to each method.

Cold Hard Cash

Advantages:

Cash is the most readily available form of money. Cash is necessary because it may be the only accepted payment at places like cabs, cash-only bars, and neighborhood lemonade stands.

Some people I know pay in cash to help stick to a budget. There is one method known as the envelope budgeting method where you cash each paycheck, divide it into various envelopes for categories of spending, and limit your spending in each category to the fixed cash outlay. This method claims to help financially irresponsible and weak people, but isn’t cheating just an ATM trip away? Oh yeah, this method will surely work.

Disadvantages:

I find that cash on hand is quickly spent, stolen, or gets run through the wash. You have to spend time to get cash from a bank or ATM, and then you end up with annoying change. Cash can even get you in trouble with the police, if you say happen to use it to shower $81,020 in a Las Vegas strip club. That would never have happened with plastic!

The Debit Card

Advantages:

The debit card is like writing a check since the purchase is taken from your checking account. Many people use debit cards since it forces you to spend money you actually have in the bank. Some debit cards are offering small rewards (though they may have fees), which is a slight benefit over using cash. Debit cards require a pin, so they have some security, and some companies may offer protection against fraudulent charges.

Disadvantages:

Debit cards are usually less safe than credit cards for online purchases–see why I used a credit card for my online business card purchase. Also, debit cards don’t offer the same level of rewards as credit cards do.

The Credit Card

Advantages:

The credit card offers you (1) security against fraudulent charges under the Fair Credit Billing Act; (2) a way to get a good immediately and defer payment till a statement comes–taking advantage of the time value of money; (3) a chance to earn cash or store rewards, and (4) a way to build a good credit reputation if used responsibly.

Disadvantages:

Used irresponsibly, a credit card can ruin your credit score and leave you with a high-rate compounding debt. People who cannot or do not pay their statements can face late fees and over a 20% APR (this is about a 22% APY; see my interest rate article on how to convert APY and APR). It’s not hard to fall into bad debt–just read some of the comments (smart) young people wrote to this article.

What do you do?

In the end of the day, people seem to have specific ideas about how to spend for things. A cab driver told me he only pays for groceries with cash, but will pay for gas on credit card since it “helps him budget.” Never made total sense to me how this would work but he was very positive every one should operate this way.

What are the ways you spend for goods? I like to keep some cash on hand for places unfriendly to plastic–but I generally use a credit card, and never use a debit card.