Understanding Overdraft Protection
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Using a debit card to buy $20 worth of gas can quickly raise the cost to $55 if you don’t have enough money in your bank account.
How? With $35 in overdraft fees from your bank to cover the $20 charge.
Getting in such a predicament is easier than you might think.
Suppose you start the day with $50 in your checking account. You buy $20 worth of gas, so your balance drops to $30.
Or so you think. A $40 check you wrote a week ago goes through and you now exceed your available balance by $10. Your bank covers that shortfall and charges you a $35 overdraft fee.
The easiest way to avoid such fees is to have enough money in your bank account when you use your debit card. But that isn’t always possible.
Another, though immediately more painful, solution is not to have overdraft protection and watch the transaction be declined. You won’t be charged for a one-time purchase, such as a cup of coffee, and you won’t be charged an overdraft fee. But who wants that when you’re at the checkout counter? And especially when you’re trying to buy something you really need immediately?
Even with the ability to check bank account balances on an app, accounts can be overdrawn with just a small purchase on a debit card linked to a checking account.
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What is overdraft protection?
If you’ve ever written a check, used an ATM, or made a debit card transaction for more money than what is available in your checking account, then you may have caused an overdraft.
Without overdraft protection, your bank may deny the purchase and charge a non-sufficient funds fee, called NSF. The merchant may also charge you $20 to $40 for a returned check fee.
We’ll discuss overdraft fees and how to avoid them, but it’s worth first understanding that overdraft protection allows you to make a transaction without being denied because your account balance won’t cover it. The bank charges a fee for that assistance, though it’s lower than NSF fees.
Overdraft protection is optional, meaning you must opt in to get it from your bank. If you do, withdrawals made for more than the account balance will be covered and you’ll pay the smaller fee of around $10.
Not having overdraft protection can lead to a transaction being declined, resulting in an NSF fee of around $35.
Overdraft protection essentially allows you to avoid the NSF fee and have the transaction approved through a linked account you have at the bank or through a credit card advance. For example, money from a savings account can be moved to cover the overdraft in a checking account. The fee is typically around $10.
If insufficient money covers a purchase, you can also decline overdraft protection and have transactions declined without a fee.
Whatever overdraft protection you get, you have to opt in for it. Federal regulations took effect in 2010, providing protections for bank customers when their deposit accounts are overdrawn. Customers must choose whether to be in a bank’s overdraft program.
By choosing to opt-in, the bank can charge you a fee to process point-of-sale or ATM transactions that exceed your balance.
Related: Best Free Checking Accounts
Better banking is here.
- No account fees
- Earn up to 4.20% APY
- Up to 2-day-early-paycheck
- No-fee Overdraft Coverage.
- Do it all in one app.
- Up to $2M of additional FDIC insurance through a network of participating banks.
Types of protection
Banks typically offer three main types of overdraft protection. Some banks offer them in different ways and charge for some and not others. The bank customer must decide if they want to opt in to any of these:
Individual transactions
If your check, ATM card, or debit card transaction exceeds your account balance, then the bank will pay for this individual transaction. Each overdraft transaction will be charged a fee up to a daily limit.
Banks may have different rules for different types of transactions. Bank of America, for example, will decline a one-time debit card purchase such as groceries or a cup of coffee, and no fee will be charged.
But if you withdraw money from its ATM and you want to take out money you don’t have in the account, the bank will ask at the ATM if you agree to its overdraft fee.
Bank of America may allow a recurring debit card payment, such as a gym or subscription service, to go through. A fee for overdrawing your account will be charged, but it won’t charge a fee if it doesn't.
The same applies to a check, bill, or scheduled electronic payment using your routing and account number. The payment may go through, causing an overdraw and a fee. If the payment isn’t allowed to go through, it may charge a fee, and the payee may charge a fee for denying it.
Line of credit
This type of overdraft protection from your bank may require a minimum annual income. It’s a line of credit that will cover the overdrawn amount.
You’ll pay a variable interest rate, and a separate fee may also be added.
Linked account
A savings, second checking, or money market account is linked to your primary checking account. When you overdraw your checking account, funds are moved to the account you overdraft. A fee will still be charged.
A credit card can also be linked to pay for overdrafts. The charges will accrue interest on your credit card.
Overdraft fees
The above types of overdraft protection all come with fees. You must opt-in with your bank to cover overdrafts and be charged such fees.
The most costly is an individual transaction. According to a survey by the Pew Charitable Trusts, most of the largest U.S. banks typically charge $35 per overdraft.
For a line of credit, overdraft protection typically costs $10 per overdraft at an APR of around 20%.
Linking an account for overdraft protection typically means paying $10 to $12 for each transfer for an overdraft. Yes, paying a fee to transfer money from one account to another sounds weird, but that’s how it works.
An overcharge payment is considered a cash advance if you link to a credit card account. Fees for this are usually high, such as 26% APR and a fee of up to 5% of the overdraft amount.
NSF fees
NSFs are charged when a check “bounces,” and the bank charges this fee, usually around $35 per check. The person or business that received the bad check may also be charged a fee by their bank.
The main point of overdraft protection is to avoid NSF fees. There’s no getting around an NSF fee if you write a check that bounces and doesn’t have overdraft protection to cover it.
NSF fees can also be charged if you don’t have overdraft protection and a debit card transaction is denied.
The cheapest option
The cheapest way to avoid any fees is to not opt-in for overdraft protection transfers. Instead, debit transactions decline if there isn’t enough money in your account to cover transactions. You won't be charged an item fee, but if you're dining out, you must have a backup plan to pay for your meal!
This option is a legal right for consumers. However, according to Pew, it only applies to debit transactions, the main way people make payments from their checking accounts.
You'll be charged NSF fees without overdraft protection for a bounced check.
Pew found that 70% of all consumers who paid debit card overdraft fees in the year before its survey was released didn’t know that they have the right to have debit transactions declined at no cost.
That means you won't have a coffee, lunch, gas, or any other on-the-spot debit transaction declined. You’ll have to find money elsewhere if you want to buy it.
Better banking is here.
- No account fees
- Earn up to 4.20% APY
- Up to 2-day-early-paycheck
- No-fee Overdraft Coverage.
- Do it all in one app.
- Up to $2M of additional FDIC insurance through a network of participating banks.
How to avoid overdrafts
Online banking has made it easier to avoid a negative balance. Overdraft protection work with financial institutions providing you with low-balance account alerts before you even get to an overdraft. Mobile banking apps have all kinds of alerts, and a low balance can remind you to stop spending with a debit card or transfer funds to your checking account.
Transfers can take a day to process, so don’t use your debit card while waiting for the funds to move.
Checking your checking account balance can also help you avoid an overdraft before shopping. You can see your available funds online, on a mobile app, by calling your bank, or at an ATM.
Many online banks have checking accounts without overdraft fees. Some may simply not process transactions if an account has insufficient funds, and you won’t face NSF or overdraft fees.
Pros and cons of overdraft protection
The purpose of overdraft protection is pretty straightforward. It prevents transactions from causing a bank account balance to fall below zero and causing an overdraft fee or a non-sufficient funds fee to be charged.
Whether you want that coverage or not is your choice. Here are some of the pros and cons of overdraft protection, as detailed earlier:
Pros
- Checks clear and ATM and debit transactions will go through.
- NSF fee avoided if you opt-in for overdraft protection.
- You must opt-in for this service from your bank.
- Checking and savings accounts can be linked to save the most on fees.
- Limit the number of fees that can be charged in one day.
- Some online banks offer overdraft protection without fees.
Cons
- Without it, you’ll be charged NSF fees if a transaction goes through.
- With it, you could still be charged other overdraft fees.
- Consumers may not know that they can decline overdraft protection and have transactions declined without a fee.
- Fees can add up to more than a purchase.
- Credit line to cover overdrawn amounts will charge interest.
- Transactions may not clear if the backup source is low or empty
Better banking is here.
- No account fees
- Earn up to 4.20% APY
- Up to 2-day-early-paycheck
- No-fee Overdraft Coverage.
- Do it all in one app.
- Up to $2M of additional FDIC insurance through a network of participating banks.
The bottom line
Overdraft protection is one of those things you may not think about until you bounce a check or have a debit card purchase denied. That’s when the bank fees can start piling up.
If that hasn’t happened, you’re managing your money well. But even then, you may want to consider opting in for your bank’s overdraft protection program so that all of your transactions go through.
Another option is to tell your bank that you want all transactions where you don’t have enough money in your account to cover them to be denied. This will avoid fees being incurred, though you must be vigilant about your account balance when you write a check.
Ultimately, that may get you to do what you should do with your bank accounts: Monitor them and stick to a budget.
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Writer
Aaron Crowe is a freelance journalist who specializes in personal finance writing and editing. He has worked at newspapers, where he won a Pulitzer Prize, and has written for numerous online publications. These include AOL, US News & World Report, WiseBread, Bankrate, AARP, and many websites focusing on housing, credit and insurance. He lives in California with his wife and daughter.
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