Learn About Overdraft Protection Plans

'Declined' message on credit card reader
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We all make mistakes. Sometimes those mistakes involve trying to spend money (by using your debit card or writing a check) when that money isn’t available in our bank account.

Overdraft protection makes it possible to spend more than you have in checking, which (sometimes) prevents your card from being declined and your checks from bouncing.

Note that banks used to automatically add this feature to all checking accounts.

Nowadays, it's an opt-in thing: you need to request it if you want it, and you might not want it (overdraft protection can be expensive and many people are better off without it).

Overdraft Protection Overview

If you have overdraft protection on your account and your account goes negative, the bank will cover certain payments for you. Assume you try to spend $100 with your debit card but you don’t have $100 in your checking account (or the funds are in your account but not yet available for spending). The bank might still approve the payment, and simply expect that you pay back the $100 later.

Of course, there are limits. You’ll find different limits on the dollar amount that an overdraft protection plan will cover. Also, you may have your privileges revoked if you frequently write checks in excess of your available balance.

The Cost of Overdraft Protection

Banks don't do this for free. They charge fees partly to keep you from abusing the service, and (not surprisingly) it creates a source of revenue for the bank.

Make sure you know what the charges will be if you’re going to add an overdraft protection feature to your account. Typically it will be similar to the Non-Sufficient-Funds fee.

Next, there may be 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, remember the bigger picture. If you use overdraft protection too often, it means you’re getting into bad habits that will cost a lot over your lifetime. It’s a sign that you haven’t managed your cash-flow well. 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.

Overdraft Protection Pros and Cons

Let’s focus on the most important thing: it costs money to have overdrafts. Obviously, the reason you had one is that you didn’t have enough money available, and now 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 you wrote the check to is not aware that you were short on cash when you wrote the check.

This keeps you from becoming embarrassed if you wrote the check to a friend or business partner.

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

Minimizing Overdraft Fees

If you must use overdraft protection programs, shop around to minimize your costs. After all, the idea is to build up the amount of money ultimately available to you. Below you’ll find some questions 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 be better than the other.
  • Can I link my 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 from, you may avoid fees.
  • Would an overdraft line of credit be more advantageous for me? Ask your banker what options are available to you. Find out exactly how each process works and figure out the consequences of each choice.

The best way to minimize overdraft protection costs is to prevent overdrafts. Aside from basic financial planning, you can keep tabs on your accounts by using the web and other technology to make sure you have the funds.

I find that people in a cash-crunch can save themselves some energy and money if they’re proactive. If you know that you’re low on cash (because you balance your budget and check your accounts online), then see if you can get a few extra days. You can call the party that you owe a check to and ask if they will wait a few days for your payment.

You can minimize problems if you keep tabs on your account:

The direct, proactive approach is better on your finances than writing bad checks or pulling out your debit card and hoping for the best.

Are Overdraft Fees Illegal?

In July of 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 some customers still pay overdraft fees (without opting in). There are two likely causes to an unexpected overdraft charge:

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

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