Understanding Overdraft Protection
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 to not 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.
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, also called NSF. The merchant may also charge you $20 to $40 for a returned check fee.
We’ll get into fees for overdrafts and how to avoid them, but it’s worth first understanding that overdraft protection is meant to allow you to make a transaction without being denied because your account balance won’t cover it. For that assistance, the bank charges a fee, though it’s lower than NSF fees.
Overdraft protection is optional, meaning you have to opt-in to get it from your bank. If you do, then 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. Money from a savings account, for example, can be moved to cover the overdraft in a checking account. The fee is typically around $10.
You can also decline overdraft protection and have transactions declined without a fee if there’s not enough money to cover a purchase.
Whatever overdraft protection you get, you have to opt-in for it. Federal regulations took effect in 2010 that provide protections for bank customers when their deposit accounts are overdrawn. They must choose if they want 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.
3 types of protection
Three main types of overdraft protection are typically offered by banks. 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:
If your check, ATM card, or debit card transaction exceeds your account balance, then the bank will pay this individual transaction for you. 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.
With a recurring debit card payment such as a gym or subscription service, Bank of America may allow the payment to go through. A fee will be charged for overdrawing your account. If it doesn’t allow the payment to go through, it won’t charge a fee.
The same is true for a check, bill payment or scheduled electronic payment using your routing and account number. The payment may be allowed to 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 having the payment denied.
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.
A savings, second checking, or money market account is linked to your primary checking account. Funds are moved to the checking account you’ve overdrawn. 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.
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. Most of the largest U.S. banks typically charge $35 per overdraft, according to a survey by the Pew Charitable Trusts.
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, it sounds weird to pay a fee to transfer money from one account to another, but that’s how it works.
If you link to a credit card account, an overcharge payment is considered a cash advance. Fees for this are usually high, such as 26% APR and a fee of up to 5% of the overdraft amount.
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, have debit transactions declined 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 need to have a backup plan for paying for your meal!
This option is a legal right that consumers have. However, it only applies to debit transactions, which are the main way people make payments from their checking accounts, according to Pew.
Without overdraft protection for a bounced check, you’ll be charged NSF fees.
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 not having a cup of 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.
How to avoid overdrafts
Online banking has made it easier to avoid a negative balance. Overdraft protection work with financial institutions providing you low-balance account alerts before you even get to an overdraft. Mobile banking apps have all kinds of alerts, and a low-balance one can remind you to either stop spending with a debit card or to transfer funds to your checking account.
Transfers can take a day to process, so don’t use your debit card while you’re waiting for the funds to move.
A checking account balance can also be checked to avoid an overdraft before you go shopping. Check your balance to see your available funds online, on a mobile app, or by calling your bank or going to 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 fees or overdraft fees.
Pros and cons
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:
- 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.
- 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.
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 to you, then you’re doing a good job of managing your money. But even then you may want to consider opting in for your banks’ overdraft protection program so that all of your transactions do 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’ll need to be vigilant about your account balance when you write a check.
Ultimately, that may get you to do what you should be doing with your bank accounts anyway: Monitoring them and sticking to a budget.