What Is an Overdraft?

Definition and Examples of an Overdraft

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When you don’t have enough money in your financial account to cover a transaction but your institution honors it anyway, you’ve been said to have an overdraft. An overdraft allows you to continue using funds in your account even when it has a negative balance, but you’re required to replace the money, and usually pay a fee.

Let’s take a look at how overdrafts work, and the different ways your bank or credit union can charge you when your balance falls below zero.

What Is an Overdraft?

An overdraft occurs when a transaction exceeds your available balance, and your bank or credit union covers the cost. With an overdraft, the financial institution still expects you to make good on the amount it fronted you. On top of that, you’re often charged a fee related to an overdraft, making the transaction even more expensive.

How Does an Overdraft Work?

An overdraft can be triggered by any action that results in a negative account balance. This might include:

  • An automatic payment deducted from your account when you don’t have enough money to cover the cost
  • A check you wrote being deposited and deducted from your account later than expected, and you don’t have the available funds to cover your next purchase
  • Making a debit card purchase in person or online and it is approved, even though there isn’t enough money in your account to cover it

When you make a purchase that brings your account balance below zero, banks decide whether to decline the purchase or pay it for you, overdrawing your account.

Most of the time, a bank or credit union will base the overdraft on your available balance—the amount of money in your account that you can spend, withdraw, or cover transactions. Sometimes, your listed balance is different from your available balance, so be sure to check your available balance and verify what the bank actually believes you can spend. Additionally, know that banks might order transactions in different ways, reducing your available balance. For example, a debit might be taken out before a credit is applied, which can result in an overdraft, even if you think you have sufficient funds in your bank account.

Depending on the bank, overdrafts will be handled in various ways. There isn’t one way to handle an overdraft. Additionally, there are different fees associated with each type of overdraft transaction and action.

Overdraft Protection

Overdraft protection is an agreement between you and your bank to cover overdrafts on a checking account, which often includes a fee. If you choose overdraft protection when you set up an account with your bank, you’re usually offered a few different options:

  • Standard overdraft practice: This is typically the default, covering certain transactions such as automatic payments and recurring debit purchases, including a gym membership or a monthly subscription service.
  • Overdraft protection: In some cases, a bank or credit union might allow you to link your savings account to your checking account as a form of backup. When an overdraft occurs, the money is automatically transferred from the linked account and deposited in the transaction account. Depending on the institution, this service might be free. For example, Chase offers this form of protection for free, whereas Wells Fargo charges a fee.
  • Debit card coverage: If you want your debit transactions to go through, even if they aren’t recurring bills, you can ask about this service. Usually, though, there is a fee associated with each transaction.

Your bank may use varying terms when referring to types of overdraft choices, so it’s important to carefully read each description. Additionally, you can decline overdraft protection and save money on overdraft fees. However, if a payment is returned due to insufficient funds, you may still be on the hook for a returned payment fee.

Overdraft Fees

Fees vary according to bank or credit union. However, the median cost of an overdraft fee is $35 per incident, according to the Pew Center on the States. Additionally, even if you have overdraft protection that involves an automatic transfer, you might still incur a fee. Pew reports that it’s common to see a fee of about $10 for these transfers, although not every bank charges this fee.

Pay attention, too, because some banks and credit unions classify overdraft protection as a line of credit. If that’s the case, you may end up paying interest on the amount of the overdraft until you pay the amount advanced to you by your financial institution.

Key Takeaways

  • An overdraft can allow transactions to go through, even if you don’t have available funds in your account.
  • Banks offer different types of overdraft protection that can allow you to continue to pay bills, even if you don’t have money in your account, often for a fee.
  • Overdraft fees can be expensive and increase the cost of a transaction.
  • Even if you don’t have overdraft protection, a transaction might still go through and result in a fee.
  • Review your bank’s policies to understand when and how it handles overdrafts.

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