Everything to Know About Overdraft Protection

a man writing a check with an invoice and calculator in front of him
••• Hill Street Studios / Getty Images

Sometimes people overestimate the number of funds in their checking account, or just simply run out of money before payday, and bounce a check because of bad timing. If you shop or pay bills by using your debit card or by writing a check when you don't have the cash in your bank account, you may be relieved to find your spending covered by your bank's overdraft protection.

Overdraft protection makes it possible to spend more than you currently have in your checking account, which can help in an emergency or if times get temporarily tough, financially speaking.

Consumer banks used to automatically add this feature to all checking accounts, but nowadays you must opt-in, or request, to use the service. You may find that you don't want overdraft protection because it can be expensive and sometimes people are better off without it.

The Mechanics of Overdraft Protection

If you have overdraft protection on your account and your balance goes negative, the bank will cover certain payments for you. Say you need to spend $100 with your debit card but you don’t have $100 in your checking account, or maybe you have the funds in your account but they're not yet available for spending.

The bank might still approve the payment, which allows you to complete your purchase, and then notify you that they expect you to deposit funds immediately to cover the $100.

You’ll find banks place different limits on the dollar amount that their overdraft protection plan covers. Also, you may have the privilege revoked if you frequently write checks in excess of your available balance.

The Pros and Cons

Most importantly, it costs money to have overdrafts. The likely reason you had one is that you didn’t have enough money available, and now with overdraft fees, you'll have even less. You can see how overdraft protection does not help you in the long run.

For some, the main benefit of overdraft protection is that the party receiving your check is not aware that you were short on cash when you gave them the check. This helps you avoid embarrassment, especially if you wrote the check to a friend or business partner.

Overdraft protection also helps you avoid penalties or late fees if you wrote a check to pay your car payment, a credit card or other bill just before its due date.

As another benefit, you can avoid bounced check fees from retailers, assuming you pay by check. If you don’t have overdraft protection, you may have to pay a Non-Sufficient Funds (NSF) fee to your bank and an additional Returned-Check fee to the retailer. Ultimately, you can end up with negative reports in your ChexSystems file.

The Cost of Overdraft Protection

Banks don't typically offer overdraft protection for free. They charge fees partly to keep you from abusing the service, and because it creates a source of revenue for the bank. Make sure you understand the potential charges before adding an overdraft protection feature to your account. The charge will typically be similar to the bank's Non-Sufficient-Funds fee.

Next, you may incur interest costs. Depending on your overdraft protection plan, the amount of your overdraft might be considered a “loan.” In that case, the bank charges interest until you repay. This option, known as an overdraft line of credit, is usually less expensive than paying a flat fee for each overdraft that hits your account.

Finally, if you use overdraft protection too often, it may allow you to get into bad habits that end up costing a lot over your lifetime. Depending on overdraft protection may be a sign that you could benefit from learning to better manage your cash flow.

Although bounced checks don't show up on your credit report immediately, they can affect how small banks and credit unions evaluate your creditworthiness. They can also cost a lot of money, lead to civil and criminal charges, and eventually damage your credit.

Minimizing Fees

If you find you do best with an overdraft protection program, shop different banks to minimize your costs. After all, it's better to keep as much money as possible for your other expenses, rather than having it used to cover bounced-check fees. Below you’ll find some questions to ask banks, that will help you find the best overdraft protection plan:

  • Is there an interest rate or flat fee for overdrafts? Depending on the frequency vs. amount of overdrafts that you experience, one method can cost less than the other.
  • Can you link your checking account to a source of funds that will be used before the overdraft feature? If you can attach a credit card, or better yet a savings account to pull cash from, you may avoid overdraft fees.
  • Would an overdraft line of credit be more advantageous for you? Ask your banker what options they have available for you. Find out exactly how each process works and the consequences of each choice.

As you may have guessed, the best way to minimize overdraft protection costs is to prevent overdrafts. Aside from doing some basic financial tracking using a check register, you can also keep tabs on your bank account balances by using online banking, or banking apps on your mobile phone, to verify the number of funds in your checking account.

If you know you'll be in a cash-crunch in the near future, it might help to address the situation proactively. Once your budget says you'll be low on cash, look for ways to stretch payment due dates a few extra days out.

You can call the party that you owe a check to, such as a credit card company, student loan holder or utility company, mention your current, temporary cash shortage, and ask if they can wait a few days for your payment. It's also wise to ask if they can waive late fees since you called ahead to let them know.

You can minimize problems if you keep frequent tabs on your checking account balance, and factor in any checks you've already written but that have yet to clear your bank account.

The Legality of Overdraft Fees

In July 2010, federal law changed how banks and credit unions are allowed to charge overdraft fees. Again, banks used to automatically add overdraft protection to your account, and there was generally no way to opt-out of this “protection.”

As a result, consumers paid billions in fees to banks for simple mistakes in their checking account. The common example was a $38 latte–$3 for the coffee and $35 for the overdraft charge.

Banks were required to turn the overdraft feature off and only offer the feature to customers who opt-in, but customers still pay overdraft fees in some cases without opting in. Two situations can likely cause an unexpected overdraft charge:

  • The bank is breaking the law and charging customers illegally, which is unlikely but has certainly happened
  • The culprit was not one of the “one-time” payments covered by the overdraft law

You can argue whether or not the law should have more broadly defined overdrafts, but the current law does not protect you from certain types of overdrafts like recurring payments that draw your account balance below zero.