Overdraft Protection

Overdraft Protection is a service offered by banking institutions on their checking accounts that covers an account holder’s transaction even if their account lacks sufficient funds. Overdraft protection can be a line of credit or a link to an additional account or credit card. They come with additional fees and/or interest.

What is Overdraft Protection?

Overdraft protection is a service that covers a checking account holder’s transaction even if the account itself has insufficient funds. Overdraft protection can be offered as an additional line of credit, a link to an additional checking or savings accounts, or a link to a credit card. While they are handy, they also come with additional fees and interest.[1]

How does Overdraft Protection work?

When a person uses their debit card (or their checkbook) to make a purchase that exceeds the amount in their checking account, the purchase is typically declined. Overdraft protection changes that. Instead of the transaction being rejected, the person’s bank or credit union provides the additional funds necessary to cover the purchase.

With some methods of overdraft protection, the money is basically a loan. The person’s banking institution provides them with a line of credit or withdraws money from a credit card that is linked to their checking account. A person can also link an additional savings or checking account and have funds transferred from that account to cover an overdraft transaction.

When the overdraft protection money is in the form of a loan, those funds will accrue interest. And with any form of overdraft protection, a fee will be charged. The dollar amount and frequency of these fees varies from one banking institution to another. Some banks will charge an overdraft fee any time you make a purchase on an overdrawn account, while others will simply charge you a fee once a day until the account’s funds are replenished.

What are the different kinds of Overdraft Protection?

  1. Line of credit
  2. With this form of overdraft protection, your bank or credit union is loaning you the money to cover your overdraft. This amount will then have to be paid back at a later date. If you make multiple purchases on your debit card before you realize you are overdrawn, then your bank will continue loaning you funds to cover those amounts. As with any form of overdraft protection, you will be charged an overdraft fee; in this case, the fees typically range from $10 to $35. And since the bank is lending you this money, they will also charge you interest on the amount overdrawn at an average Annual Percentage Rate (APR) of 18 percent.[2]

  3. Link to another account
  4. With this form of overdraft protection, your bank or credit union automatically links your account to another checking or savings account. If you overdraw your checking account, the overdraft protection then transfers funds over to cover the amount withdrawn. With this option, there is still an overdraft fee, but it is usually far more reasonable: $5-$10.[3] And since your bank is using your own money to cover your overdraft—instead of providing you with a loan—they do not charge interest on the transferred funds. This is by far the most affordable form of overdraft protection. However, it also means having sufficient funds in an additional savings or checking account, which can be difficult for many borrowers.

  5. Link to a credit card
  6. This form of overdraft protection works much the same as linking your checking account to a savings account or additional checking account. By linking your checking account to a credit card, funds from that card can be used to cover any overdraft made on the account. Just like any other form of overdraft protection, there will be a fee. Actually, there will be two fees, because credit card companies treat overdraft protection as a cash advance. In addition to getting charged a transfer fee by your bank, you will also be charged a cash advance fee by your credit card company. Cash advance fees are typically two to five percent of the amount withdrawn. Plus, cash advances charge a higher interest rate than typical credit card transactions. The average rate on a cash advance fee is roughly 23 percent.

What is the purpose of Overdraft Protection?

Overdraft protection exists so that people with insufficient funds in their account can still make purchases. For instance, without overdraft protection, someone who didn’t have the money in their checking account to pay their electricity bill could be left without power in their home. Overdraft protection allows them to pay that bill and then pay off the overdraft charges later on.

In this way, overdraft protection is often compared to small-dollar “instant cash” loan like payday, title and pawn shop loans. However, these comparisons also extend to the higher rates that most banking institutions charge in overdraft fees and interest.

In 2015, the three largest bank in America made $6 billion in overdraft and ATM fees alone.

Overdraft protection has also proven to be very profitable for banking institutions. In 2015, the three largest bank in America (JPMorgan Chase, Bank of America, and Wells Fargo) made $6 billion in overdraft and ATM fees alone.[4] Some see overdraft fees as a way for banks to profit off of low-income customers.[5]

Is Overdraft Protection mandatory?

No.

Since 2010, banking institutions have been required to ask customers whether or not they “opt in” to overdraft protection for ATM and debit card transactions. But you could still incur overdraft fees for writing a check or for funds withdrawn through online bill payments.

References

  1. “Overdraft Protection.” Investopedia. Retrieved September 20, 2016 from http://www.investopedia.com/terms/o/overdraft-protection.asp
  2. Fontinelle, A. “What are the pros and cons of overdraft protection?” Investopedia. Retrieved September 20, 2016 from http://www.investopedia.com/ask/answers/071114/what-are-pros-and-cons-overdraft-protection.asp
  3. Bernardo, R. “Overdraft Protection: What It Is & How to Avoid Fees.” WalletHub. Retrieved September 20, 2016 from https://wallethub.com/edu/overdraft-protection/11307/
  4. Long, H. “ATM and overdraft fees top $6 billion at the big 3 banks.” CNN Money. Retrieved September 20, 2016 from http://money.cnn.com/2016/01/14/investing/atm-overdraft-fees/
  5. Bell, C. “Bank overdraft protection: do you need it?” Bankrate. Retrieved September 20, 2016 from http://www.bankrate.com/finance/savings/bank-overdraft-protection-do-you-need-it-1.aspx