Understanding How Overdraft Protection Works

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Even the most budget-conscious person can overestimate their checking balance and overdraw their account from time to time. Overdraft protection helps you to avoid incurring non-sufficient funds (NSF) fees, which financial institutions could charge when you don’t have enough cash in your account to cover a transaction.

The trouble is institutions have widely varying terms for overdraft protection plans: Some are free; others charge additional fees. Confusing, right? Pay a fee to avoid a fee?

If you don’t grasp fully how it works, you aren’t alone. A survey by The Pew Charitable Trusts found that overdraft protection isn’t widely understood by bank customers. In fact, Pew found that nearly three out of four people who overdraw their account don’t realize that they have the right to have transactions declined without a fee if their account can’t cover the purchase.

Although it has the potential to help, you have to understand the terms of the plans available to you. Let’s take a closer look at the different options.

What is overdraft protection?

An overdraft is when you write a check or make an ATM or debit card transaction for an amount that’s more than the funds available in your checking account. Banks and credit unions typically charge NSF fees when you overdraw your account. Overdraft protection covers the difference if you overdraw your account and prevents you from incurring an NSF fee.

Broadly speaking, three plans are available from financial institutions:

  1. Standard overdraft coverage for individual transactions: The bank will pay the overdraft amount for check, ATM card and debit card transactions. Banks generally charge you for each overdraft transaction, up to a daily limit.
  2. Overdraft protection line of credit: A line of credit will transfer funds to cover the overdrawn amount and any fees charged. The overdrawn amount is subject to a variable interest rate, and each overdraft might incur a separate fee. Note: Some banks might require a minimum annual income for this type of overdraft protection.
  3. Linked account overdraft protection: Your checking account is linked to another account, such as a savings, money market, credit card or second checking account. Your primary checking draws funds from the linked account if you’re overdrawn. However, the transfer of funds might result in an overdraft fee.

In 2010, the Federal Reserve issued a rule regulating overdraft practices that banned banks from enrolling customers in overdraft protection automatically. Now banks must allow customers to opt in and opt out at any time.

Overdraft protection fees

If you opt in, your financial institution might charge a fee to cover check, debit card and ATM overdrafts. This fee typically is a fixed amount that’s charged per overdraft item. These are the fees associated with the three general types of overdraft protection plans detailed above:

  1. Standard one-time overdraft protection: Typically $34 per overdraft, and an additional fee might apply if your account remains overdrawn for a certain length of time.
  2. Overdraft protection line of credit: Typically at least $10 per overdraft and an APR of around 20% charged on the covered amount.
  3. Linked account overdraft protection: Typically $10-$12 per transfer. If you link a credit card account in this way, payments are considered to be cash advances. This means paying an APR of at least 26% or more on the overdraft amount, plus a fee that could be as much as 5% of the overdraft amount.

Although you potentially can be charged an overdraft fee multiple times if you continue to overdraw your account, banks typically limit the number of fees you can be charged in one day. If you refuse overdraft protection, your bank or credit union will decline your transaction, so you won’t be charged an overdraft fee, but you might be charged an NSF fee.

What is the difference between an overdraft and NSF?

If you don’t have overdraft protection when you try to make a purchase without having sufficient funds in your account, the bank or credit union will deny the transaction and charge you the NSF fee. States limit the amount a bank can charge, typically ranging from $20 to $50.

If you don’t have sufficient funds in your account to cover a transaction but you’ve opted in, you avoid paying an NSF fee and the transaction is accepted. You still might be charged an overdraft fee, however. NSF and overdraft fees are somewhat similar, but at the end of the day, they’re different animals.

Is overdraft protection right for me?

It’s difficult for us to recommend a plan that charges fees. Replacing NSF fees with overdraft fees is a poor strategy if you have trouble keeping your checking account balance high enough to cover your expenses.

The sole advantage of overdraft protection is that your transactions aren’t denied. If you have to make an emergency purchase for any reason, it gives you peace of mind—for a price.

For example, say you have a $0 balance in your account but your car has a flat tire. You have your checkbook, so you can pay for the tow and service. In this case, overdraft protection is helpful.

People who live paycheck to paycheck or who have inconsistent income might be tempted to rely on overdraft protection to cover necessary purchases when they might not have the money. However, overdraft fees are an extremely expensive way to cover necessary expenses. A much better strategy is to learn how to make a budget and stick to it.

When it’s smart to pass on overdraft protection

It’s smart to skip overdraft protection if you aren’t good with budgeting, because the service can become a crutch that makes you less likely to pay attention to your spending. Overdraft fees can stack up fast when you’re shopping and you don’t realize you’re overdrawing your checking account.

For example, say your checking account charges a $34 overdraft fee up to four times per day. You’re unaware you have a low $10 balance in your checking account. At the mall, you use your debit card to make three separate purchases: pants for $20, a book for $10 and a coffee for $5. You spent $35 on merchandise while racking up $102 in overdraft fees.

In the example above, it’s obvious that it would’ve been better to opt out of overdraft protection and have your financial institution deny the charges. A better strategy would be to choose an checking account with no overdraft fees, such as the ones below, that don’t let you overdraw your account and don’t charge NSF fees:

  • Aspiration: Aspiration simply doesn’t process transactions when your account has insufficient funds. It has no overdraft protection plan, and the account doesn’t charge NSF fees.
  • Simple: Simple states that its accounts “minimize” overdrafts. Transactions that are more than your account balance typically are “declined or returned.” Best of all, Simple charges neither overdraft fees nor NSF fees.
  • Moven: Like Aspiration, Moven simply declines any transactions that would overdraft your account, resulting in no NSF fees or overdraft fees.

How to avoid overdrawing your account

The tips below provide more strategies to avoid overdrawing your account. They also are best practices when it comes to your financial life:

  • Don’t overspend. You might have trouble managing your spending, which might lead you to overdraw your account. As we noted above, you should learn how to create a budget to get a better picture of your finances and see where you can cut costs to avoid overdrawing your account. It almost goes without saying, but 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 run 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 might run into issues if you write checks in advance of having the necessary funds in your account. Although you might expect to have the funds in your account when the check is cashed, things might change and result in you lacking enough funds to cover the check.

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