Living beyond your means can cost you twice. There’s the actual payment that you can’t cover and the corresponding overdraft fee, which adds insult to injury by charging you a penalty for drawing money you don’t have. It’s an expensive and frustrating cycle, but knowing how to use your financial institution’s overdraft protection service to your advantage can help you break free.
An overdraft happens anytime the money coming out of an account exceeds the amount available for use. Since this creates a negative balance, a financial institution will typically assess a non-sufficient funds or overdraft fee — Investopedia suggests an average of about $35. If you are enrolled in what NerdWallet’s Spencer Tierney calls a courtesy pay or overdraft privilege program, your financial institution will complete a one-time debit card purchase or ATM withdrawal as requested even if it overdrafts your account. The financial institution will assess the non-sufficient funds fee but may not always notify you when your account has a negative balance. Additional purchases made with the overdrawn account result in more NSF fees, and your account may be hit with an extended overdraft fee if left unattended for several days.
It is at your financial institution's discretion whether it will cover any recurring transaction, automatic bill payment or checks. If they do not, then your payment will not clear or your check will bounce. Not only will this lead to a returned-check fee or overdraft fee, but it will result in a late payment that can carry penalties and fees all its own and will have a negative impact on your credit score.
The upsides and downsides of overdraft protection
To better protect consumers from unexpected overdraws, most financial institutions now offer a service called overdraft protection. Investopedia likens overdraft protection to a line of credit offered by the financial institution and applied to an account whenever it is overdrawn. You may also have the option to link your checking account to a credit card or to a savings account with the same financial institution to cover any overdrafts.
Perhaps the greatest benefit of overdraft protection is avoiding the embarrassment of a bounced check or declined card. The Balance’s Justin Pritchard writes that overdraft protection can help you avoid other penalties or late fees assessed if the transaction in question is paying a bill or making a credit card payment. This also negates the undesirable effect that a late payment or bounced check will have on your credit score.
It’s important to note that overdraft protection is not free. Borrowing money from a linked checking or savings account is likely the cheapest option. Tierney writes that you can expect to pay a fee of around $10-$12 for the transfer, and that you may only be charged that fee once per day as opposed to once per transaction.
If you are borrowing against a credit card, Investopedia writes that the transfer of funds is tantamount to a cash advance, which means that it both carries a cash advance fee and a high rate of interest. Borrowing against a financial institution's line of credit also carries a high rate of interest, but this may prove cheaper than an NSF fee if you pay the balance owed back quickly. Investopedia notes that financial institutions may charge a one-time fee for every month that you rely on overdraft protection if you rely on it too much.
The best solution by far for avoiding overdraft fees and penalties is to be proactive about maintaining your account. Check your balance regularly, budget accordingly and never spend more than you have available. By doing so, you will never need to rely on overdraft protection even if it is a service available to you.