Understanding How Overdraft Protection Works

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Understanding how overdraft protection works
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Have you ever written a check for an amount you didn’t have in your account and incurred a fee? Or have you ever been embarrassed by a declined debit card transaction? If the answer’s yes, you’ve had experience with overdrawn checking accounts.

You may have heard about overdraft protection and how it may help you pay for expenses when you lack the funds in your account. While this service has the potential to help you in times of need, it’s important to be aware of the drawbacks. In this post, we’ll discuss the ins and outs of the various types of overdraft protection, and how you can avoid overdrawing your account in the future.

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What is overdraft protection?

Overdraft protection is a way to fund an account that has been overdrawn. Without this service, you would most likely be charged an overdraft or non-sufficient funds (NSF) fee and have your transaction declined. The fees can add up every time your account is overdrawn, but this service can provide a safety net if you withdraw too much money.

How does overdraft protection work?

There are three types of overdraft protection that work in slightly different ways. While they ultimately transfer funds to your overdrawn checking account, the fees charged differ.

Here are the three options you may have for overdraft protection:

  1. Opt in for overdraft coverage for ATM and one-time debit card transactions. By opting in, you authorize the bank to pay any overdrafts from ATM and one-time debit card transactions. Beware banks often charge you high fees.
  2. Link your checking account to an eligible savings, secondary checking, money market account or line of credit like a credit card. If your account is overdrawn, funds will be transferred from your linked account. There is often an overdraft protection fee associated with the transfer of funds.
  3. Overdraft protection line of credit. If you overdraw your account, the line of credit transfers funds to cover the amount overdrawn plus any fees charged. The amount you overdraw is subject to a variable interest rate and a fee. Note, some banks may require a minimum annual income to open an overdraft protection line of credit.

Overdraft protection fees

If you have overdraft protection and overdraw your account, you will most likely be charged a fee. This fee is often a fixed amount that is charged per overdraft item and varies based on the protection you have.

Here are the fees associated with the options detailed in the previous section:

  1. Opt in for overdraft coverage for ATM and one-time debit card transactions: Typically $34 per overdraft item and an extended overdraft fee may apply if your account is overdrawn for a certain amount of days.
  2. Link your checking account to an eligible savings, secondary checking, money market account or line of credit like a credit card: Typically $10-$12 per transfer.
  3. Overdraft protection line of credit: Typically $10 or more per transfer, plus an APR of around 20% charged on the amount transferred.

While you can potentially be charged the fee multiple times in one day if you continue to overdraw your account, banks typically limit the amount of times you can be charged the fee in a day.

Understanding the overdraft protection law

In 2010, the Federal Reserve passed a law regulating overdraft practices for one-time debit card and ATM transactions. The law banned banks from automatically enrolling customers in overdraft protection for these transactions.

Prior to this law being passed, banks were allowed to process one-time debit card and ATM transactions in which consumers lacked the necessary funds and were charged an overdraft fee. But, the law changed that practice and required banks to allow customers to opt in or opt out of overdraft protection at any time.

If you opt in, the bank will process your one-time debit card and ATM transactions and charge a fee. While if you opt out, the bank will decline your transaction and won’t charge you an overdraft fee — but they may still charge an NSF fee.

The benefits of opting in to overdraft protection

Transactions are approved. This service may be helpful if you need a transaction to go through and can’t afford to have it declined in cases of emergencies or upcoming due dates on bills.

Less embarrassment when paying. If you’re someone who lives from one paycheck to the next, you may run into instances where you’re short of funds for needed expenses like groceries. It can be embarrassing to have your debit card declined due to insufficient funds, and this service may help you avoid those situations.

When can you benefit from overdraft protection?
You may benefit from overdraft protection if you find yourself in a situation where you don’t have the money to cover the cost of an unexpected emergency. For example, say you have a $0 balance in your account but your car broke down because of a flat tire. In this situation, you have your checkbook but don’t have the needed cash or credit card to pay for the tow and service on your card.

If you enrolled in this service and linked an eligible savings account that has the needed funds, you could write the check. Then, the bank would transfer the funds from your savings account to your checking account. You would be charged a $10-$12 overdraft transfer fee, but that’s minor compared to the typical $34 NSF you would be charged if the check bounced.

The drawbacks of using overdraft protection

Fees may still apply. If you enroll in overdraft protection, you may still be charged fees, such as an overdraft protection fee or an NSF fee. And you may incur multiple fees in one day.

High fees for overdrafts funded by credit cards. If you use a credit card to fund your overdraft, it is considered a cash advance which often comes with high APRs over 25% and a cash advance fee that is 3% or 5% of your withdrawal.

When is overdraft protection not worthwhile?
If you opt in for overdraft protection on ATM and one-time debit card transactions and make unnecessary transactions when you have a $0 balance, you can see fees add up quickly. For example, say your account charges a $34 overdraft fee up to four times a day. You’re unaware you currently have a $0 balance in your checking account.

You decide to go to the mall and use your debit card to make three separate purchases: pants for $20, a shirt for $10, and a hat for $8. In total you spent $38 on clothes, but incurred $102 in overdraft fees. That makes the effective cost of your clothing purchase an alarming $140. It’s pretty obvious that it would’ve been a better decision to opt out of the service for ATM and one-time debit card transactions so those transactions would’ve been declined.

Which type of accounts can be linked to a checking account for overdraft protection?

You can link several accounts to your checking account for overdraft protection, including: savings, secondary checking account, money market or line of credit like a credit card. Note that linkable accounts may vary by bank, so refer to your overdraft protection agreement for eligible accounts.

How to avoid overdrawing your account

If you want to prevent future overdrafts, the tips below may help you avoid overdrawing your account, and are general best practices when it comes to financial products:

  • Open a checking account with no overdraft fees. There are banks that offer checking accounts with no overdraft fees. So, instead of being hit with the average $34 fee, banks most likely will decline the transaction — if you aren’t opted into overdraft protection.
  • Don’t overspend. You may have trouble managing your spending, which may lead you to overdraw your account. You can create a budget to get a better picture of your finances and see where you can cut costs to avoid overdrawing your account. A good rule of thumb is don’t spend more than you can afford.
  • Set up low balance alerts. Many banks allow you to set alerts when your balance reaches a certain amount. This is a helpful feature that can make you aware when funds are running low and when you should minimize spending.
  • Review your account balances. It’s important to keep track of how much money is in your checking account. You can keep a register or log in to online banking to stay up-to-date on your account balance. This way, you know how much you can afford to spend.
  • Don’t write checks before you have the money in your account. You may run into issues if you write checks in advance of having the necessary funds in your account. While you expect to have the needed funds in your account when the check is cashed, things may change and result in you lacking the funds to fulfill the check.

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Alexandria White
Alexandria White |

Alexandria White is a writer at MagnifyMoney. You can email Alexandria at [email protected]