Considering Overdraft Protection? Here Are the Pros and Cons
Overdraft protection can be a handy last line of defense. But the more you use it, the more dangerous it becomes to your financial wellbeing.
Nobody likes having a card declined. That’s why people sign up for overdraft protection, Even if you don’t have the cash in your account, overdraft protection will have you covered.
But here’s the thing: overdraft protection could actually be providing you the opposite of protection. It could be posing a huge threat to your long-term financial stability.
So which is it? Well, the answer’s a little more complicated than that.
What is overdraft protection?
Overdraft protection comes in a couple different forms, but the basic idea is this: If you make a transaction on your debit card that exceeds the funds in your account, overdraft protection will provide you with the extra money you need to cover it. Of course, this service won’t often be performed free of charge, but it does save one the embarrassment of having their card declined.
The first type of overdraft protection comes by linking the checking account to another account, most likely a savings account or a credit card. (Some banks will let you link multiple accounts.) If the account owner then overdraws their checking account, funds are transferred in from that linked account to cover the transaction. A transfer fee will usually be charged.
The other type of overdraft protection is an overdraft line of credit. With this form of overdraft protection, your bank is essentially loaning you money to cover the cost of your overdraft. Depending on the bank, you might get charged interest on this line of credit, and you will almost always be charged an overdraft fee to cover the transaction.
What are the pros of overdraft protection?
The most obvious upside to overdraft protection is that it will save you the embarrassment of having your card declined or having a check bounce. While having a card declined can be deeply embarrassing, a bounced check will likely result in a hefty Non-Sufficient Funds (NSF) fee and a black mark on your banking history.
If your overdraft protection involves a linked savings account, you’re not actually borrowing money to cover the shortfall. You’re using your own money, which can prevent you from overloading yourself with debt. And the transfer fees for linked account transfers are usually fairly reasonable.
A final argument for overdraft protection is that it allows you to cover emergency expenses, even if you don’t currently have the funds in your account. Otherwise, you’d be stuck with high-interest bad credit loans and predatory no credit check loans like cash advances and title loans.
Even if overdraft protection isn’t a great option, it’s definitely better than a predatory payday loan, right?
What are the cons?
Actually, overdraft protection might not be much better than a predatory payday loan. Even after legal reforms in the wake of the 2008 financial crisis that prevented banks from automatically opting customers into overdraft protection, overdraft fees are still a huge business.
And those fees are on the rise. In 2017, American consumers paid over $34 billion in overdraft fees alone, the most they’ve paid since 2009.
In some ways, overdraft protection is a much better proposition for banks that it is for their customers. So much so that the line between overdraft protection and predatory lending can get very blurry indeed—starting with the fees.
Overdraft fees are high, with an average fee of $30. And when customers are using an overdraft line of credit instead of a linked account, many banking institutions will charge a separate overdraft fee for every transaction that exceeds the account balance. Imagine paying $34 on a five small $4 transactions. That’s $170 in fees for $20 in spending, an effective interest rate of 850 percent!
And since many banks prioritize processing large transactions before they process smaller ones, the likelihood that you’ll rack up multiple overdraft fees is high. Getting charged one $34 fee on a $600 transaction wouldn’t leave you feeling great, but it’s a heck of a lot better than getting charged those $34 fees on the ten smaller transactions that came after it.
Lastly, while avoiding an NSF fee is great for your Chexsystems Consumer Score (which is like a credit score for your banking history), overdrafts are also recorded on your Chexsystems report. Too many overdrafts and you could find yourself unable to open a checking account for the next five years.
So is overdraft protection a good idea?
Sort of. The thing about overdraft protection is that it’s just like any other kind of emergency bridge financing. Overdraft protection can be great as your last line of defense—an account feature that gives you peace of mind, even if you almost never use it. But if you find yourself regularly overdrafting your account, overdraft protection is a bad idea.
For people with low incomes and bad credit, overdraft protection can end up trapping them in a dangerous cycle of debt. Those fees eat away at their account balances, which then lead them to overdraft even more frequently.
If this sounds like you, go ahead and shut off your overdraft protection. Sure, dealing with the embarrassment of having your card decline is going to suck, but clawing back all that money that’s currently going towards overdraft fees is well worth the trade-off.
Finally, if you are going to use overdraft protection, make sure it’s through a linked savings account instead of a credit line. Even linking a credit card to your checking account is a better option than an overdraft line of credit. The fees are lower, the interest rates are more manageable, and you can use your card’s 30-day interest-free grace period to your advantage.
There are very few easy answers in personal finance. The pros and cons of overdraft protection will ultimately be decided on a case by case basis—by what works best for you. To learn more about managing your finances, check out these related posts from OppLoans:
- What’s the Quickest Way to Fix Bad Credit?
- How to Save Money When You’re Already on a Tight Budget
- From Budget to Baller: 6 Tips to Grow Your Money
- 8 Ways To Save Money Today, Tomorrow and Every Day After
The information contained herein is provided for free and is to be used for educational and informational purposes only. We are not a credit repair organization as defined under federal or state law and we do not provide "credit repair" services or advice or assistance regarding "rebuilding" or "improving" your credit. Articles provided in connection with this blog are general in nature, provided for informational purposes only and are not a substitute for individualized professional advice. We make no representation that we will improve or attempt to improve your credit record, history, or rating through the use of the resources provided through the OppLoans blog.