Definition, when you might need it
- Overdraft protection is a service that allows you to overdraw your checking account.
- Some banks offer services that cover your overdrawn checking account with money from another account.
- The overdraft protection service fee is different from the insufficient funds (NSF) fee.
- Read more stories from Personal Finance Insider.
Swiping your debit card at the grocery store to be declined for insufficient funds or writing a bouncing rent check can be not only embarrassing, but also costly due to associated penalties and fees. Overdraft protection services, offered by most banks, are one way to avoid this embarrassment and reduce the costs incurred in such circumstances.
What is overdraft protection?
There are several types of overdraft protection, all designed to do the same thing: cover you when you make a transaction for an amount that exceeds your account balance. Debit card and ATM transactions will be approved and checks will still clear even if you’ve gone over your budget and don’t have enough money to cover them.
There are usually fees associated with overdraft protection, which vary depending on your bank and the type of service you use. With increased competition in commercial banks, you may also be able to find a bank that offers overdraft protection at no cost.
How does overdraft protection work?
If you opt for your bank’s basic overdraft protection service, it will cover the payment and charge you a fee when you spend more money than you have in your account, up to certain limits . Fees are usually around $35 per transaction. In addition, you must redeposit the excess amount withdrawn. In some cases, these costs can add up quickly if you make multiple transactions before you realize you’ve exceeded your balance.
Financial institutions may also offer other types of overdraft protection services, including:
- Linked savings account: Most banks allow customers to link their checking accounts to another bank account, such as a savings account. When an overdraft occurs, the bank transfers money from the savings account to the checking account. Banks typically charge a transfer fee for the service which is usually lower than standard overdraft fees.
- Linked credit card: Some financial institutions will allow you to link your credit card to your checking account. If you make a transaction that exceeds your account balance, your credit card will be charged. Your bank may also charge a fee for this service.
- Credit line: Some banks and credit unions also offer an overdraft line of credit. When you open a line of credit, your bank transfers funds to your checking account each time you exceed your account. The amount used to cover the overdraft bears interest until it is fully repaid.
However, not all financial institutions charge overdraft fees. And the rise of online-only banking, also known as
or challenger banks – makes it more and more likely that you can find one that offers overdraft protection for little or no fee at all.
“There was a time when nearly every bank charged overdraft fees, but now there is a movement to eliminate or reduce overdraft fees in the banking industry,” says Jennifer White, Principal Consultant, Financial Services Practice at JD Power .
Many people often confuse the overdraft protection service fee with the insufficient funds (NSF) fee. Without overdraft protection, your checks will bounce, debit card transactions will be declined, and funds transfers will not complete. When this happens, most banks charge NSF fees.
There are also other consequences that come with failed transactions, including merchant fees and account cancellation. Since many people find such situations embarrassing, they sign up for overdraft protection that allows transactions to be completed even with insufficient funds.
Example of overdraft protection
Consider the following scenario. Suppose John goes to a local store to buy some products and writes a check for $1,400 to a checking account with $900. Since John signed up for overdraft protection by linking his savings account to a checking account, the check will clear even with the $500 less. However, the bank will charge him a transfer fee of $10 for the service.
Conversely, if John did not have overdraft protection, the check would bounce due to insufficient funds. The bank may also charge him an NSF fee or even cancel his checking account in such a situation. The retailer would likely also charge John a fee for bouncing the check.
Do I need overdraft protection?
“Overdraft protection can save you the fees and damage to your credit rating associated with not paying on time,” says Ann Martin, COO of CreditDonkey. “In most cases, overdraft protection means your bank will complete a transaction if you don’t have sufficient funds.”
Plus, signing up for overdraft protection can help cover emergency costs in times of crisis. Even if you don’t have enough cash in your checking account, transactions will still be completed. While overdraft protection sounds like a good deal, it also has some downsides.
Here are some of the pros and cons of overdraft protection.
Before signing up for overdraft protection, it’s important to weigh the pros against the potential downsides that come with the service. Additionally, considering your budget and spending habits will help you make a wise decision.
White says everyone should link their accounts in some way as a general safety net.
“This is important even if your bank is eliminating overdraft fees, because it’s a solid money management action on its own,” she says. “This reduces your potential risk of charges (as many banks still charge overdrafts) and allows you to manage your money with peace of mind. This protection should however be considered in case of irregular use, as balance monitoring is an essential to sound financial behavior.”