If you shop or pay bills 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 program.
By definition, overdraft protection is a service that instructs your bank to pay for a transaction when you don't enough money in your checking account. In exchange, your bank charges you what is known as an overdraft fee.
Consumer banks used to automatically add this feature to all checking accounts, but nowadays you must opt in, or formally accept, the service. Understanding how overdraft protection works can help you determine if it's right for your spending habits and budget.
Mechanics of Overdraft Protection
If you don't have the funds in your checking account to cover a transaction, the bank will cover it for you in certain cases and charge you an overdraft fee.
Say you need to spend $100 with your debit card but don't have $100 in your checking account, or maybe you have sufficient funds in your account but they're not yet available for spending.
If you opted in to overdraft protection, the bank would still approve the debit purchase, allowing you to complete your purchase. However, your account would at that point be overdrawn—that is, you'd have a negative account balance. The bank would assess an overdraft charge and request that you deposit funds immediately to cover the $100. If you didn't opt in, however, the bank would decline the transaction and wouldn't charge you the overdraft fee.
The opt-in provision of the overdraft protection service only applies to one-time debit and ATM transactions. If you write a check or make a recurring payment that would overdraw your account, your bank may still pay for it on your behalf and assess an overdraft fee even if you didn't opt in. But it may also choose not to pay for it, in which case you won't get hit with an overdraft charge. However, you may still have to pay a non-sufficient funds (NSF) fee that is comparable to the overdraft fee. You typically won't pay this fee when a debit card transaction is declined. If a bank returns a check unpaid, you may also have to pay a returned-check fee.
Pros and Cons of Overdraft Protection
The main benefit of overdraft protection is that it helps you pay emergency expenses even if you're short on cash. You can also avoid the penalties or fees that would have applied had you made a late payment because of temporary money troubles. As another benefit, you might avoid bounced check fees from retailers, assuming you pay by check and the bank allows it to clear. The party receiving the payment won't be aware that you were running low on funds when you paid them. This helps you avoid embarrassment, especially if you sent payment to a friend or business partner.
That said, overdraft protection isn't cheap, and the per-transaction fee can make it especially costly if you use it regularly. You might even be charged multiple overdraft charges in a single day. The likely reason you incurred the fee is that you didn’t have enough money available, and with overdraft fees, you'll have even less. Also, the bank may revoke the service if the banks feels as though you're using it irresponsibly. To make matters worse, repeated overdrafts can show up as negative items in your ChexSystems report, which can keep you from getting approved for a bank 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 need to learn to better manage your cash flow.
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.
Different banks impose different overdraft fees; however, a standard per-transaction fee of around $35 applies. Banks may also place different limits on the dollar amount that their overdraft protection service covers. Make sure you understand the potential charges before opting in to overdraft protection.
If you have a line of credit attached to your checking account as a backup funding source, you may incur interest costs since the overdraft would be considered a “loan.” Known as an overdraft line of credit, this option usually requires you to pay a fee when the credit line is tapped, but it's usually less expensive than paying a fee for each overdraft that hits your account.
The median overdraft fee is $34 for the nation's 50 largest banks and $31 for smaller banks and credit unions.
As you may have guessed, the best way to avoid overdraft charges is not to opt in to the service, which can often prevent overdraft charges. But if you intend to opt in to an overdraft protection program, shop different banks to reduce your costs. Get the answers to a few key questions to find the bank with the most affordable overdraft protection plan:
- What is the fee for overdrafts? With this figure in mind, consider the frequency and amount of overdrafts that you experience to determine whether the service would cost you less at one bank than another.
- Can you link your checking account to a backup funding source that will be used before the overdraft feature? If you attach a savings account to pull cash from, for example, you may be able to avoid overdraft fees and interest costs.
- Would an overdraft line of credit be more advantageous? Ask your banker what fee will apply when you tap the line of credit and what interest rate you'll pay on money you borrow.
The most effective way to minimize overdraft protection costs while you're opted in is to reduce the number of overdrafts you make. Aside from doing some basic financial tracking using a check register, also keep tabs on your bank account balances by using online banking, or banking apps on your mobile phone, to verify the funds in your checking account and any uncleared checks before you spend.
If you know you'll be in a cash crunch in the near future, address the situation proactively. When your budget says you'll be low on cash, look for ways to stretch payment due dates a few extra days out. For example, call the party that you owe payment to, such as a credit card company, student loan issuer, or utility company, mention your current 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.
Legality of Overdraft Fees
In July 2010, federal law changed how banks and credit unions can charge overdraft fees. Again, banks used to automatically add overdraft protection to your account, and you often had to opt-out of this “protection.”
As a result, consumers paid 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 not unheard of.
- The purchase is 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 understanding how overdraft protection works under the current law can keep you from incurring overdraft charges for transactions that aren't covered.