Overdrafts - How they work and how you can avoid them
Let's talk about the dreaded overdraft fee. Commonplace in modern banking, but mostly avoidable, there is a lot to unpack about overdrafts. Let's start with a review of the different kinds of overdrafts, then we can talk about smart ways to avoid them altogether.
What is an overdraft?
An overdraft happens any time you spend more from a depository account than you have on deposit. Unlike a credit card where you have a line of credit to spend against, debit cards, ATMs, and checks all need to be tied to available funds in your account. A lot of overdrafts stem from the timing of deposits versus expenses.
Let's say that it's a Monday and your rent ($1000) is due on Tuesday. You currently have $750 set aside to pay your rent, but you need to deposit a check you just received for $500 to get the total balance up so that you can pay your $1000 rent. If you deposit that check at an ATM or a bank branch today (Monday) before the deposit cutoff (which differs wildly from bank to bank), it should arrive in your account by Tuesday morning in time for the new check to go out to your landlord. If you don't make the cutoff time for deposits, even if it is still Monday when the check is deposited into the ATM, the funds might not arrive until Wednesday, in which case your account will be overdrawn by the issuance of your rent check. Make sure you know the cutoff times at your bank, as it can make a significant impact on your finances. Overdrafts can happen, even if you are on top of your finances. Knowing how your specific bank handles an overdraft is the first step to preventing them.
Overdraft Coverage vs. Overdraft Protection
Overdrafts fees can add up to significant amounts in a short amount of time, so as a way of protecting consumers, Congress passed the Overdraft Protection Law in 2010. In short, the law makes the default for transactions to be to fail or "be declined" instead of defaulting to overdrawing an account. The only way that a bank can now allow you to overdraw your account is if you have either Overdraft Coverage or Overdraft Protection. (Definitely check with your bank directly to see how they describe their overdraft charges, but this is the most common terminology).
Overdraft Coverage is a service extended to bank customers. If a customer writes a check and there are insufficient funds to pay the check, your bank will pay the check but will charge you a fee ($30 or more) for the service. You have to opt-in to utilize this service at your bank, and if you don't have this, or Overdraft Protection in place, that check will not be paid and will instead be returned.
Overdraft Protection, similar to Overdraft Coverage, is something that you have to sign up for with your bank. Instead of the bank covering small overdrafts in your account for a set fee, Overdraft Protection allows you to link another account (like a savings account at the same bank) to serve as an emergency overdraft fund. If you wrote the same check, and your balance was short of funds, the bank would move funds out of your savings account to cover. Some banks charge for the transfers between accounts, so definitely check the fine print on your banking agreement.
Overdrafts via ACH or Check
If you write a check and at the time of deposit those funds are not available in your account, your bank or credit union will likely honor the check, overdrawing your account by the difference between the current balance and the amount of the check. For the service, you will immediately be charged an "overdraft fee," which is usually around $30 (but increasing every year). You are also responsible for paying back the difference between your account balance and the check amount.
Overdrafts via ATM or Debit Card
If you go to an ATM and request funds exceeding your balance, one of two things will happen. If you have agreed to an "Overdraft Coverage Plan" through your bank, you will be allowed to overdraw your checking account and will be charged an overdraft fee in addition to the difference between your current balance and the amount of your withdrawal. If you have not authorized your bank's Overdraft Protection program and if you try to either spend money on your debit card or take out cash from an ATM above your current balance, your request will be declined.
When do overdraft fees get charged?
If you use your debit card to buy something and you have Overdraft Coverage at your bank, you will be charged a fee, and it will probably look like this:
(1) Bank balance $1,000
(2) Debit Transaction ($1,100)
(3) New bank balance ($100)
(4) Overdraft charge ($30)
(5) New bank balance ($130)
It is vital to note that your new balance will include the overdraft fee as well as the amount of the initial overdraft. In the above example, overdrawing your account by -$100 will mean that your actual balance is -$130 (or more). This fee can also be assessed multiple times on the same day for different charges. If you overdraw your account first thing in the morning, you will pay a fee, which will further overdraft your account, and if you have additional charges hit that account, you will be assessed an additional fee per transaction. Any additional charge to your account will result in an additional overdraft charge until the entire account is in good standing, and all fees are paid.
Overdraft charges can add up quickly and create some meaningful account problems, but there are simple things that you can do to prevent them from happening in the first place.
Always check your balances
The first and best way to prevent overdraft related charges is through knowledge of your accounts. On any given day, you should have a pretty good idea of how much you have in an account, how much of it is earmarked for future expenses and how much can be spent. Most banks have a mobile application to allow you to check your balance any time of day, and some even provide notifications for when your account balance drops below a certain level. If you would like to get notifications for all of your accounts in one place as well as some automations to make sure your funds are where they are most needed - there is an app for that.
Be your own Overdraft Protection
Depending on the bank that you use, you may be able to utilize an Overdraft Protection Plan, where you link another account to your checking account so that your bank can automatically cover your possible overdrafts. Everyone should try and keep a separate savings account for emergencies, and using it as the back up for your regular checking account can make that account even more useful. If you are interested in how to get started with a savings account and why they are essential - check out our savings vs checking article. Be sure and get the details of how your bank organizes overdraft protection as some charge for the covering transfers. If your bank does, you might want to find another bank.
Don't sign up for Overdraft Coverage
Although when you are talking with a banker at a branch, it might sound like Overdraft Coverage is required, but it is legally optional (per Congress). By enabling Overdraft Coverage at your bank, you are allowing them to permit charges on your account that will put it in overdraft status - and charge you the associated fee. If you opt-out of getting Overdraft Coverage, then if you try and spend more money than you have in that account (in most circumstances), the transaction will be declined, which can be inconvenient, but in the long term, it can be a far cheaper option.
Hopefully, with a few of these tips, you can avoid future overdrafts and the fees they bring. If you do find yourself with an overdraft fee, though, here are some great ideas on how to get your bank to waive them.