Overdraft

Overdraft: Fees, Protection, and How It Works

What is an overdraft?

An overdraft occurs when a bank allows transactions to go through even though an account lacks sufficient funds. It functions as a short-term loan from the bank to cover payments that would otherwise be declined or returned.

Key takeaways

• Overdrafts let you complete transactions when your balance is zero or negative, but banks typically charge fees and interest.
• Overdraft protection links a checking account to a savings account, another account, or a credit line to cover shortfalls.
• Relying on overdrafts frequently can be costly and may lead a bank to remove the service.
• Regulators have acted against unfair overdraft practices (for example, reordered transactions to maximize fees).
• An unused overdraft can be a short-term credit option with interest often lower than credit cards, but costs vary.

How overdrafts work

• When a transaction would create a negative balance, the bank may cover it and treat the amount as a loan.
• Common charges include a one-time overdraft fee per item (often several tens of dollars) and interest on the outstanding overdraft balance.
• Some banks charge additional insufficient funds (NSF) fees when items are returned instead of covered.
• Regulators have penalized banks for practices that increased overdraft fees unfairly; some banks have been required to stop certain fee practices and refund customers.

Overdraft protection options

Overdraft protection is a way to prevent returned transactions by linking backup funding sources:
* Linked savings or another checking account: automatic transfers cover shortfalls, usually with a transfer fee or lower charge than an overdraft fee.
* Linked credit card or line of credit: the bank advances funds from the credit line; this may increase your credit card balance and could affect credit utilization.
* Courtesy or discretionary coverage: some banks automatically cover small overdrafts as a customer service, while charging a fee.

Banks typically require you to opt in for certain types of protection. Protection reduces the likelihood of returned items and merchant declines but often carries fees or interest.

Managing overdrafts and credit implications

• If the bank covers the overdraft with its own funds, the account holder’s credit score is usually unaffected—unless the debt is sent to collections.
• Using a credit card or line of credit for overdraft protection increases debt on that instrument and can affect your credit score through higher utilization or missed payments.
• If overdraft balances go unpaid for an extended period, banks can turn the debt over to collections, which may be reported to credit bureaus.

Overdraft fees

• A typical overdraft involves a per-item fee and possible interest on the borrowed amount.
• NSF fees may apply if the bank returns items instead of covering them; fees can add up quickly when multiple transactions are involved.

Pros and cons

Pros
* Prevents returned checks and declined transactions.
* Provides a short-term financing option in emergencies.
* May be cheaper than carrying a credit card balance in some cases.

Cons
* Per-item fees and interest can be costly, especially with repeated use.
* Excessive reliance may lead to loss of the service or account closure.
* Poorly managed overdrafts can lead to collections and negative credit reporting.

Tips to minimize overdraft costs

• Opt out of overdraft coverage for debit card and ATM transactions if you prefer transactions to be declined rather than paid with fees.
• Link a savings account or low-cost line of credit for overdraft protection.
• Set alerts for low balances and review account activity frequently.
• Keep a small buffer in your account to cover unexpected charges.
• Reconcile automatic payments and scheduled transfers to avoid surprising shortfalls.

The bottom line

An overdraft can be a useful short-term safety net, but it carries costs and potential credit consequences if mismanaged. Understand your bank’s fees and protection options, use overdraft protection sparingly, and prioritize account practices that reduce the chance of overdrawing.