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Overdraft protection allows ATM and debit card transactions, payments and checks to go through even if you don’t have enough funds in your bank account. When funds are unavailable, your bank will often charge you a fee for overdrafting.
Have you ever been in a situation where you go to pull out funds from an ATM, but those funds aren’t available in your account? This is where overdraft protection comes in handy. Overdraft protection is an optional service that most banks offer, allowing you to withdraw money or use checks even if the funds aren’t in your account.
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. According to the 2021 FinHealth Spend Report, overdraft fees cost consumers roughly $12.4 billion in 2020.
As with most financial services, overdraft fees have their pros and cons. We’ll break down the benefits and downsides of overdraft protection here as well as some additional details and tips that can help you better manage your finances.
Key takeaways:
- Overdraft protection allows you to make a transaction with a check, at an ATM or via wire transfer even when you don’t have the available funds.
- Overdraft protection can be helpful, but it may also have high fees, depending on which type of account you have linked.
- The protection limit for overdrafts can range anywhere from hundreds to thousands of dollars.
What is overdraft protection?
Overdraft protection allows ATM and debit card transactions, payments and checks to go through even if your bank account doesn’t have enough funds. Without overdraft protection, the transaction would be rejected. Most banks and credit unions offer overdraft protection for your savings and checking accounts.
How does overdraft protection work?
Overdraft protection works by you having an agreement with your financial institution to allow funds to be withdrawn for a fee, even if you don’t have enough. This is different from a cash advance you can get from an ATM.
When a charge occurs beyond your available 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.
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 is an example of overdraft protection?
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.
Pros and cons of overdraft protection
There are benefits and downsides to overdraft protection, and 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, it’s helpful to understand what the service is and what you’re responsible for should you use it.
Pros
Although there are fees associated with overdraft protection, there’s a reason people use it. Some of the benefits include:
- Checks clear and ATM withdrawals process even when you don’t have enough money
- It enables you to have funds or cash when you need it in an emergency
- It gives you access to cash between paychecks
- It limits high fees related to insufficient funds, bounced checks or having your bank account closed (in extreme cases)
Cons
Before you decide on an overdraft protection checking account, here are the downsides to consider:
- It’s expensive, with high overdraft protection fees and interest
- Transactions may not clear if you exceed the allowed limit
- It encourages spending money you don’t have available
- It creates a false sense of financial security
Types of overdraft protection
Should you decide to add overdraft protection to your account, there are a few different types you should know about:
- Linked deposit account: A checking or savings account is linked to the protected account, and the transaction pulls from the backup account if you’re low on funds. There are still fees, but they may be slightly lower.
- Linked credit card: Similar to a linked checking or savings account, this gives you a cash advance from a credit card. This also has a fee along with interest for the amount borrowed.
- Overdraft line of credit: This uses an established line of credit that you borrow against, which also comes with transaction fees and interest.
Is there a limit on overdraft fees?
Some financial institutions also charge a monthly fee for providing overdraft coverage. The cost of overdraft protection depends on your bank. A recent Forbes survey found that the average fee is about $24.38, with some banks charging more than the average. There might be other fees incurred for each day the account has a negative balance.
Banks and credit unions often have a limit for overdraft protection, such as a few hundred dollars. 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.
Is it good to have overdraft protection?
As we covered above, there are pros and cons to having overdraft protection. Whether the service is right for you is based on your personal financial situation. If you’re often low on funds between paychecks or have inconsistent income, overdraft protection can provide you with money when you need it. For some, having access to money is worth the fees and interest that come with overdrafting their account.
One reason overdraft protection may not be a good idea is if you’re already accumulating debt. Overdraft protection gives a false sense of security that you can spend more than you have, and it can put you further into debt. This will hold you back from meeting your financial goals in the future.
What are the alternatives to overdraft protection?
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
FAQ
In addition to the overdraft protection basics, there are some frequently asked questions that may provide some more clarity on this service.
What is misleading about the term “overdraft protection”?
For some, the language of “overdraft protection” is a bit misleading because it can be interpreted as protecting you from overdrafting by simply stopping the transaction. Instead, the account overdrafts and charges fees. Knowing how this service works should clear up any confusion.
Do you have to have overdraft protection?
No. Overdraft protection is an optional service through your bank or credit union. Without it, transactions won’t go through when you don’t have enough money in your account.
What does $200 overdraft protection mean?
If you have $200 in overdraft protection, this means you’re able to borrow up to $200. For example, if you have $5 in your account, you can make a charge on your debit card of $205. You’ll then need to pay fees and interest on that $200.
What will overdraft protection do to my 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.
How to avoid overdraft fees
If you’re struggling financially, don’t worry—it’s possible to get back on the right track so you don’t have to worry as much about overdrafting your account and dealing with high fees and interest. And if your credit is damaged due to overdrafts, help is available.
Lexington Law Firm has a team of credit repair professionals who could help you work toward improving your credit, and we also have services to help you with money management. All of our clients have access to our financial education services, so you’ll learn how to avoid overdrafts and set yourself up for financial success. To learn more about how we can help, contact us today.
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