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Raquel Garcia is serious about avoiding debt. The 18-year-old customer-service representative for U-Haul (UHAL) recently canceled her credit card. Now she gets her entire paycheck deposited onto a prepaid debit card, which she uses for all her purchases. Since she can access only what's in the account, Garcia no longer worries about breaking her budget: "I'm spending just what I need."

For consumers reeling from a series of economic body blows, debit cards are increasingly becoming the plastic of choice. Some use the cards, which pull money directly from a bank or other account, as a budgeting tool to limit spending. Others are embracing them out of necessity as banks clamp down on credit. All told, debit purchases are expected to climb 13% in 2008, to $1.2 trillion, according to The Nilson Report, an industry newsletter—compared with a 3% rise, to $1.9 trillion, for credit-card transactions. At Visa (V), the No. 1 card company, debit spending could surpass credit this year.

For the banks issuing the debit cards, the trend seems bittersweet. On the plus side, debit cards don't pose a threat to the banks' books like credit-card accounts; losses are mounting as borrowers fall behind on their payments. But the profits on debit cards aren't as plump since banks don't collect interest on them. Issuers largely make money from fees, which pale next to those on credit cards. Retailers, for instance, fork over 1.6% of credit purchases to banks, three times the amount on debit transactions.

But don't shed a tear for the banks just yet. Time and again they've shown an uncanny ability to adapt to a new profit landscape, and the debit-card business appears no different. Consider the evolution of overdraft fees. It used to be that banks denied debit purchases when consumers didn't have enough money in their accounts. Now 14 of the 15 largest banks approve transactions but hit customers with a fee if they exceed the funds. It's not unlike getting charged for bouncing a check. A recent study by Web site Bankrate.com (RATE) found that overdraft fees now approach $29, up 3% in the past year.

Those penalties are easier to trigger, too. In the past customers had up to a couple of days—the time it takes for some debit transactions to clear—to deposit cash. But now many banks hit them with fees as soon as purchases are made. "Banks have turned to this as a major source of revenue," says Jean Ann Fox, director of financial services at the advocacy group Consumer Federation of America.

The practices have become so prevalent that the Federal Reserve has proposed rules that would rein in perceived abuses. The banks argue that they provide a necessary service to consumers. "There's a balancing act to ensure folks who do need to occasionally go over the limit have [the protection] while having a deterrent in place for people who abuse it," says Doug Johnson, a policy adviser at the trade group American Bankers Assn.

The Next Frontier

Regulatory headwinds haven't deterred the banks from ramping up their debit-card businesses. Among the groups that offer the biggest potential for banks: people who earn more than $75,000 a year. According to MasterCard (MA), they're the least active debit users, usually turning instead to credit cards that offer frequent-flier miles and other rewards.

To attract that crowd, financial firms are ramping up their loyalty programs. MasterCard's Savings program, launched in October, offers debit users discounts on luxury brands like Armani and 7 For All Mankind as well as at retailers such as Home Depot (HD) and Target (TGT). San Antonio's Frost Bank (CFR) recently released its Momentum card, which is connected to customers' checking or savings accounts. The bank pays customers a higher interest rate on the accounts—up to 3.5%—when they make more debit purchases.

There's also a land grab for the so-called underbanked, the roughly 80 million people who don't have a bank or credit-card account. Dallas' Comerica Bank (CMA) won the right this year to issue debit cards to the estimated 4 million Social Security recipients who don't have bank accounts. The government deposits the money onto a prepaid card. (Comerica doesn't charge overdraft fees on them.) Visa and MasterCard offer prepaid debit cards that companies use to pay employees.

The aggressive push is paying off. These days, debit cards are as widespread as credit cards. At the upscale suburban Atlanta restaurant Aqua Blue, waitresses now bring diners a device that lets them swipe their debit card and enter their password to pay for meals. "Debit is becoming the payment card of choice for the American public," says Red Gillen of consultancy Celent.

But for consumers like Garcia who want to break free from the high fees and penalties of credit cards, debit cards may not be the panacea they expected. Says consumer advocate Fox: "As with credit cards, consumers can't keep up with what the rules are."

The troubles sound familiar. Borrowers falling behind on their payments. Defaults rising. Huge swaths of loans souring. Investors getting burned. But forget the now-familiar tales of mortgages gone bad. The next horror for beaten-down financial firms is the $950 billion worth of outstanding credit-card debt—much of it toxic.

That's bad news for players like JPMorgan Chase (JPM) and Bank of America (BAC) that have largely sidestepped—and even benefited from—the mortgage mess but have major credit-card operations. They're hardly alone. The consumer debt bomb is already beginning to spray shrapnel throughout the financial markets, further weakening the U.S. economy. "The next meltdown will be in credit cards," says Gregory Larkin, senior analyst at research firm Innovest Strategic Value Advisors. Adds William Black, senior vice-president of Moody's Investors Service's structured finance team: "We still haven't hit the post-recessionary peaks [in credit-card losses], so things will get worse before they get better." What's more, the U.S. Treasury Dept.'s $700 billion mortgage bailout won't be a lifeline for credit-card issuers.

The big firms say they're prepared for the storm. Early last year JPMorgan started reaching out to troubled borrowers, setting up payment programs and making other adjustments to accounts. "We have seen higher credit-card losses," acknowledges JPMorgan spokeswoman Tanya M. Madison. "We are concerned about [it] but believe we are taking the right steps to help our customers and manage our risk."

But some banks and credit-card companies may be exacerbating their problems. To boost profits and get ahead of coming regulation, they're hiking interest rates. But that's making it harder for consumers to keep up. That'll only make tomorrow's pain worse. Innovest estimates that credit-card issuers will take a $41 billion hit from rotten debt this year and a $96 billion blow in 2009.

Those losses, in turn, will wend their way through the $365 billion market for securities backed by credit-card debt. As with mortgages, banks bundle groups of so-called credit-card receivables, essentially consumers' outstanding balances, and sell them to big investors such as hedge funds and pension funds. Big issuers offload roughly 70% of their credit-card debt.

But it's getting harder for banks to find buyers for that debt. Interest rates have been rising on credit-card securities, a sign that investor appetite is waning. To help entice buyers, credit-card companies are having to put up more money as collateral, a guarantee in case something goes wrong with the securities. Mortgage lenders, in sharp contrast, typically aren't asked to do this—at least not yet. With consumers so shaky, now isn't a good time to put more skin in the game. "Costs will go up for issuers," warns Dennis Moroney of the consultancy Tower Group.

Sure, the credit-card market is just a fraction of the $11.9 trillion mortgage market. But sometimes the losses can be more painful. That's because most credit-card debt is unsecured, meaning consumers don't have to make down payments when opening up their accounts. If they stop making monthly payments and the account goes bad, there are no underlying assets for credit-card companies to recoup. With mortgages, in contrast, some banks are protected both by down payments and by the ability to recover at least some of the money by selling the property.

THE BIG BOYS' BURDEN

Making matters worse, the subprime threat is also greater in credit-card land. Risky borrowers with low credit scores account for roughly 30% of outstanding credit-card debt, compared with 11% of mortgage debt. More than 45% of Washington Mutual's credit-card portfolio is subprime, according to Innovest. That could become a headache for JPMorgan Chase, which agreed on Sept. 25 to buy the troubled thrift's credit-card business and other assets for $1.9 billion. Says a JPMorgan spokeswoman: "