What is Overdraft Protection?

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Definition:

With overdraft protection, your financial institution will process a transaction even if your account balance falls below zero.

🤔 Understanding overdraft protection

Overdraft protection will transfer money into your checking or savings account if you overdraw it (spend past your available funds). Without overdraft protection, if you write a check, but don't have the funds to cover the payment, it will bounce (be rejected). Likewise, if you charge something to your debit card, but have insufficient funds in your account, your payment would be declined. With overdraft protection, your bank or credit union can transfer money from a linked account into your checking account, covering the transaction. Your bank or credit union may also cover the payment by extending a line of credit and having you repay it later. In either case, however, you will likely be on the hook for overdraft fees.

Example

On the way home from work, you decide to pick up some groceries. You load up the basket and check out. As the clerk swipes your debit card, you remember that your checking account has a low balance. Suddenly, your stomach twists into knots. Will the payment be accepted? It is! Your bank sends an email a few minutes later, informing you that you overdrew your account. They've transferred funds from your linked savings account to cover the payment and have charged you a $12 transfer fee.

Takeaway

Overdraft protection is like a surge protector...

If you spend too much with your debit card, your bank will automatically take steps to process the payment and transfer funds into your account — to prevent your account from “breaking,” just like a surge protector may prevent a temporary excess of power from frying your laptop. However, your bank may charge hefty fees for these services.

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What is overdraft protection?

Overdraft protection allows a financial institution to transfer funds to cover you if you overdraw your bank account. You can overdraw a checking or savings account by charging something that you can't cover with your balance (the amount of money currently available).

Let's say you have $1,000 of available funds in your savings account and a $300 checking account balance. You're at the store and buy a $500 television with a debit card connected to your checking account.

If you don't have overdraft protection, your bank or credit union will try to process the payment but find insufficient funds. As a result, the payment will be declined. This could be embarrassing, and you'll have to leave the store without a TV. You may also have to pay a non-sufficient fund (NSF) fee to your bank.

If you have overdraft protection, your bank may still process the payment. Since you have $1,000 in your savings account, your bank can initiate an overdraft protection transfer to put funds into your checking account from your savings account.

For this to happen, you have to link your savings account and checking account through your bank's overdraft protection program. Many banks will charge for this transfer. The median transfer fee is about $10.

The bank may still cover the charge if you have insufficient funds in your savings account or have not linked an account. With overdraft protection, your bank may extend credit, essentially providing a small loan. You'll most likely have to pay interest and other fees.

Besides debit card purchases, overdraft protection can also cover ATM withdrawals, ACH (Automated Clearing House) transfers, and checks. Overdraft protection may be available for both your checking and savings accounts, depending on your bank.

Why use overdraft protection?

Overdraft protection can save you from the embarrassment of a declined payment and allow you to purchase goods even if your account balance drops below zero. You also won’t have to deal with the hassle of having to transfer funds and can still make some purchases while you’re waiting for more money (like your next paycheck) to be deposited.

However, overdraft protection can still result in expensive overdraft fees. These fees can add up. If you overdraw your account multiple times, even in one day, your bank or credit union may charge you every time depending on their policy.

What are overdraft fees?

Overdraft fees are the charges your bank or credit union will charge you if you overdraw your account. Overdraft protection doesn't protect you from these fees. If you opt-out of overdraft protection, your bank cannot charge you overdraft fees, but you won’t be able to overdraw your account.

Banks typically charge around $35 per overdraft. Some banks will charge a fee for each overdrawn purchase. So, if your account is empty and you buy a $5 latte in the morning, a $10 lunch, and $25 in groceries on the way home from work, you could be assessed a fee for each charge.

Some banks limit the number of overdraft fees charged per day. Bank of America will charge a maximum of four overdraft fees per day. Chase will charge a maximum of three fees. Either way, it's possible to run up $100 or more in fees quickly.

How can you avoid overdraft fees?

First, you can opt-out of overdraft protection. If you use your debit card but don't have the funds to cover the purchase, your bank or credit union will reject the payment. Unfortunately, however, some financial institutions will still charge a Non-Sufficient Funds (NSF) fee when this occurs, which may be as expensive as an overdraft fee.

In 2009, the U.S. Federal Reserve Board issued a rule that banks and credit unions must have customers explicitly opt into overdraft protection. This rule came into effect on January 1st, 2010. Before that, many banks would enroll their customers automatically.

Many banks and credit unions also allow you to connect another bank account or credit card to your account. If you overdraw your checking account, for example, funds can be transferred from your credit card or savings account.

Financial institutions don't usually charge “overdraft fees,” as such, for this service. They may charge an overdraft protection transfer fee, however, but it's typically less than an overdraft fee. If your linked account is with the same bank as your overdrawn account, charges are often less or waived entirely.

Budgeting can also help people avoid overdraft charges. It’s a good idea to always ensure that you have money in your checking account before deciding to make a purchase. Before making a big transaction with your debit card, check your balance, and make sure you have enough to cover it.

Also, watch your scheduled bills and their impact on your balance. For example, if you have regularly scheduled mortgage payments or automobile loan payments, make sure money is in your checking account before the funds are sent.

How much can you overdraft?

Each bank or credit union will generally set its own overdraft limits. Typically, you can overdraft between $100 to $1,000. When you overdraft an account and the bank pays for it, rather than transferring funds from another account, you're essentially getting a loan.

The bank will usually consider your credit history, banking activity, deposits, and other factors when deciding whether to extend an overdraft line of credit. If you regularly overdraw your account or already have outstanding and unpaid overdrafts, your bank may be more likely to decline to cover the payment.

What does overdraft mean for your credit?

An overdraft does not directly affect your credit score. With checking and savings accounts, you're spending your money. Credit bureaus don't typically monitor this banking activity since you’re not using credit.

If you overdraw your account and have funds transferred from another account, it won't impact your credit score. But banks do use another credit-like agency, ChexSystems. Some banks may refuse to provide you with an account if you have a lot of overdrafts or outstanding negative balances.

Also, if the bank extends credit and covers the charge, it could affect your score if you don't pay the loan back on time. Your bank or credit union could send the debt to a collection agency. Next, the agency will generate an account for you, which will appear on your credit report. This will create a delinquency, which will be on your credit report for seven years.

What are the pros and cons of overdraft protection?

Pros

  • Overdraft protection could allow you to make purchases even when you don't have sufficient money in your account. No one wants to have their card declined, and many people would find it embarrassing. If your bank or credit union processes the payment, you'll be saved from an awkward situation.
  • Being able to overdraft can be particularly handy if you’re in a financial pinch. For example, if you have no food and need to buy groceries, overdraft protection should allow you to complete your purchase. However, many banks add additional fees if you don’t pay off the overdraft quickly, so it’s best to use overdrafts when you know you’ll have money within a few days.

Cons

  • You may be able to avoid non-sufficient fund fees with overdraft protection, but the overdraft fee could be just as expensive.
  • You could also be charged multiple overdraft fees in a single day. If your bank charges a NSF fee, you’ll likely only be hit with it once and will know not to use your card again after it’s declined.

Is it a good idea to have overdraft protection?

Whether overdraft protection is a good idea depends on your specific situation and the fees charged by your financial institution. Make sure to read the fine print so that you understand the potential costs and obligations.

Some banks and credit unions may not charge a non-sufficient funds (NSF) fee for a declined payment. Other institutions will levy an NSF that's just as costly as an overdraft fee. Likewise, some will transfer your funds from one account to another for free. Others charge for this service.

If your bank doesn't charge an NSF fee, and you believe you'll regularly overdraw your account, you may be better off without overdraft protection. On the other hand, if you can connect your checking account to a savings account and won't be charged a transfer fee if you overdraw, overdraft protection likely makes more sense. Ultimately, the best solution is to ensure that you have sufficient funds in your account to cover any charges.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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