How Does Overdraft Protection Work?

What Is Overdraft Protection?

Overdraft protection is a service offered by banks and credit unions that allows customers to avoid declined transactions and other penalties when they try to spend more money than they have in their checking accounts. With overdraft protection, if you try to make a purchase or withdraw cash that exceeds your available balance, the bank will either cover the difference themselves or use funds from another one of your accounts to cover it.

One thing to know is there are fees associated with overdraft protection. Depending on your bank, overdraft fees can be around $35 per transaction. Some banks also charge daily or continuous overdraft fees for each day your account remains overdrawn. As you can imagine, fees can add up quickly.

Usually, when you first open the account, you'll have the choice to opt in to overdraft protection. If you agree, your bank can charge an overdraft fee for any transaction that overdraws your account. You won't be charged a fee if you choose not to opt in, but if a purchase causes your account to become overdrawn and you don't have overdraft protection, your bank may refuse the transaction. This is what happens when someone's card gets declined.

Overdraft protection can provide peace of mind for those who worry about accidentally overspending or facing unexpected expenses. Still, it's important to understand the fees and terms associated with this service before opting in.

Types of Overdraft Protection

Not all overdraft protection is alike, and different accounts offer various types of protection. Here are some common types of overdraft protection and features:

• Linked bank accounts: This is the most common type of overdraft protection, in which your checking account is linked to another account such as a savings account or, in some cases, a line of credit. If your checking account lacks the funds needed to cover a transaction, the bank will automatically transfer money from your linked account to cover the difference.
• Credit cards: Some banks offer credit card overdraft protection, where customers can link their checking account to a credit card and use it as a backup funding source when their checking account has insufficient funds. Your bank may require you to use one of its credit cards for this type of overdraft protection.
• Line of credit: A line of credit allows you to borrow money up to a certain limit, but you'll only pay interest on what you borrow. To use it to cover the transactions your checking account can't cover, your bank may allow you to link your checking account to your line of credit.
• Overdraft fees: Some banks offer overdraft protection by charging you an overdraft fee when you don't have enough money to cover your purchase or transaction. With overdraft fees, the bank covers the difference and charges a fee for each transaction.
• Opting out: Most banks allow you to opt out of overdraft protection altogether. In this case, if you don't have enough money in your account to cover a transaction, it would be declined rather than covered by the bank.

Be sure to carefully review the terms and fees associated with each type of overdraft protection before choosing one.

Pros and Cons of Overdraft Protection

To decide whether overdraft protection is right for your financial situation, looking at the pros and cons can be helpful.

Pros

• Avoid declined transactions: Overdraft protection can prevent transactions from being declined due to insufficient funds, which can be embarrassing and inconvenient.
• Save money: It might seem counterintuitive, but you'll typically pay less overall if you opt in to coverage. The cost to maintain overdraft protection is usually cheaper than paying an overdraft fee, especially if you wind up paying multiple overdraft fees.
• Emergency coverage: Knowing that overdraft protection is in place can provide a little peace of mind if you're worried about accidentally overspending or facing small unexpected expenses. (But don't neglect your emergency fund!)
• Convenience: Overdraft protection can save time and hassle by avoiding transferring funds manually between accounts.

Cons

• Fees: Overdraft protection can come with many costs, which can add up quickly if used frequently. Plus, even if you never use the coverage, you may still pay for it depending on your bank's policies.

• Debt accumulation: Using credit cards or lines of credit for overdraft protection can rack up debt, especially if the balances aren't paid off promptly.
• False sense of security: Overdraft protection can provide a false sense of security that may lead to overspending and financial instability.
• Potential impact on credit score: Late payments or high balances on credit cards or lines of credit used for overdraft protection can negatively impact your credit score.

How to Avoid Overdraft Fees

The fees that come with overdrafts—whether you have coverage or not—can add up quickly. Luckily, there are some ways you can avoid paying overdraft fees:

• Track your spending. Keeping track of your expenses can help you avoid overspending. Now is an excellent time to start if you need a budget. At the very least, keep a close eye on your available balance.
• Create a buffer. Give yourself some breathing room in your checking account by keeping a minimum balance. Transferring money from savings can help prevent overdrafts.
• Enroll in alerts. Many banks offer email or text alerts that notify you when your account balance falls below a certain amount, which can help avoid overdrafts.
• Link to another account. The easiest way to avoid fees and additional debt is to link your checking account to a savings or another checking account, for automatic transfer in case of an overdraft. That way, you're just using your own money to cover transactions instead of the bank's.
• Opt out of overdraft protection. If you don't want to incur overdraft fees, you could opt out of overdraft protection altogether and just have ATM and debit transactions declined when you don't have enough money in your account (or, ideally, make sure you have enough money in your account to cover transactions). Keep in mind, however, you could still be charged an overdraft fee on checks and ACH transactions.
• Negotiate with your bank. If you get charged an overdraft fee, it's worth contacting your bank to see if they'll waive it as a one-time courtesy.

The Bottom Line

Overdraft protection can be a helpful tool for managing your finances and avoiding the embarrassment of declined transactions. However, it's essential to understand how it works, the potential drawbacks and your unique financial personality and habits. Together, this information can help you avoid costly fees and maintain better control over your finances.

Ultimately, no matter what you decide, taking proactive steps and being mindful of your spending habits can avoid costly overdrafts and surprise fees and help you on your journey to achieving financial stability.