What Is Overdraft Protection and How Does It Impact Your Credit?

Overdraft protection allows ATM and debit card transactions, payments and checks to go through even if your bank account doesn’t have enough funds. Most banks and credit unions offer overdraft protection for your savings and checking accounts. 

While having overdraft protection might seem like a good idea, there are often high fees associated with it. Each time you overdraw—even by a few dollars—a hefty fee and potential interest can be charged to your account. 

How Does Overdraft Protection Work?

Overdraft protection works by having an agreement with your financial institution to allow funds to be withdrawn for a fee, even if you don’t have enough. 

When a charge occurs beyond your balance, overdraft protection kicks in and allows the transaction to go through. The funds are transferred to whomever or whatever is requesting it, such as an ATM or utility company. The funds are provided by your financial institution since there’s not enough in your account.

overdraft protection example

Each time you request funds beyond the balance, you’re charged an overdraft transfer fee. Generally, if you make many purchases, you’ll be charged for each transaction. You might also be charged interest on the amount until you repay it to the bank. 

What Fees and Limits Should I Expect?

Some financial institutions also charge a monthly fee for providing overdraft coverage. The cost of overdraft protection depends on your bank but is generally around $35 per transaction. There might be other fees incurred for each day the account has a negative balance. 

Most banks don’t charge for overdrafts less than $5. For example, if you have $2 in your account and you buy a $4 latte, you wouldn’t be charged for an overdrawn account. Chase is an example of one institution that does not charge for overdrafts less than $5.

Banks and credit unions often have a limit for overdraft protection, such as $750 to $10,000. Once you go this far beyond your balance, you won’t be able to use more funds. Check with your bank to learn about fees and limits when it comes to overdrafting on your account.  

In general, those without overdraft protection pay much less in fees.

Example of how overdraft protection works

Jeremy is out for lunch with friends at a cash-only restaurant. He takes $20 out of the ATM, but his account only has $11. The ATM gives him the $20 because he has overdraft protection. The bank charges him a $32 fee. 

His $15 dollar lunch now costs him $47 ($15 + $32 for overdrafting). If he makes more purchases before bringing his balance back up, he’ll be hit with another overdraft fee. 

Is Overdraft Protection a Good Idea?

Whether overdraft protection is a good idea or not depends on your financial situation and the fees your bank charges. Before using an overdraft service, make sure you understand the charges and interest that you could be applied to you. Compare those costs with the costs of not having overdraft protection. Consult with a financial advisor or similar professional for guidance on your situation. 

Here are a few pros and cons to consider with overdraft protection: 

Pros

Having overdraft protection can help you in certain situations, such as when you’re in a bind for cash. 

  • Allows transactions to go through, checks to clear and ATM withdrawals to process when you don’t have enough money.
  • Enables you to have funds or cash when you need it in an emergency.
  • Gives you access to cash between paychecks.
  • Limits high fees related to insufficient funds, bounced checks or having your bank account closed (in extreme cases). 

Cons

Overdrafts can be expensive and lead to money mismanagement. Review the fine print to ensure you understand the terms of your bank’s overdraft protection. Terms vary with all financial institutions and credit unions.

  • It’s expensive with high overdraft protection fees and interest (they add up)
  • Transactions may not clear if you don’t have enough cash
  • Encourages spending money you don’t have available
  • Creates a false sense of financial security 

What Are the Alternatives?

Besides overdraft protection, there are other ways to avoid spending more than you have. By law, overdraft protection is an opt-in service and not something you have to do when you open a checking or savings account. 

Instead of overdraft protection, keep your finances safe by: 

  • Signing up for email or text alerts when your account is low in funds.
  • Using a transfer service that automatically transfers money from another linked account (for example, from your savings to your checking) when your account balance is low.
  • Monitoring your online banking account for spending, unusual activity and a low balance.
  • Downloading a mobile banking app so it’s easy to check your available balance.
  • Using your credit card for purchases that you can pay off at the end of the month.
alternatives to overdraft protection

Does Overdraft Protection Hurt Credit?

Overdraft protection itself does not hurt your credit, but it can impact your credit if you link your credit card to your checking account or if the overdrawn amount goes to collections.  

When a line of credit is used to cover the overdraft, it can prompt a hard inquiry on your credit report. Check with your bank to see how they handle reporting to the credit bureaus. If your overdraft amount is sent to collections, it could appear as a negative mark on your credit report. 

If you tie your bank account to your credit card for overdraft, some credit card issuers will treat overdraft payments as cash advances. These transactions are more costly and risky (e.g. higher interest rates, no grace period, cash advance fees). If you don’t have enough available funds in your credit card or line of credit, the transaction may be declined anyway. You may be charged an overdraft fee regardless.

When you use credit to cover insufficient bank funds, the situation can get worse if you can’t pay off the overdraft costs. It impacts you in two ways:

  • First, when you miss payments because you can’t cover the amount, your credit score takes a hit. Missed payments are the top factor in determining your credit score.
  • Second, you’ll have a higher credit utilization rate—the second most important aspect of your credit score. Higher credit utilization occurs when you use a higher percentage of your total available credit.

How Else Can I Improve My Finances?

Decide if overdraft protection is right for you by looking at your financial situation and your bank’s terms. In most cases, overdraft services are expensive. 

Regardless of what you decide, it’s vital to practice good financial habits. Paying off your credit cards on time and not overspending or overusing your credit cards can enhance your finances and improve your credit score. Boost your financial wellbeing by fixing your credit and raising your credit score.