Overdraft protection is a policy where a bank allows you to spend more money than you have in your account in exchange for a fee. Some consumers like the convenience of this to avoid the embarrassment of having a purchase rejected or facing larger penalties for having bills and checks returned for insufficient funds. However, consumers do not always realize how much they pay for this convenience. It is often free to sign up for overdraft protection; the money is to be made in the fees that are assessed.
With overdraft protection, overdraft fees are charged for each transaction that exceeds your balance, whether it is by check, debit card, or electronic transfer. This is in contrast to either having a purchase rejected by a vendor at point-of-sale or having to pay insufficient funds (NSF) fees, which may be greater than the overdraft fees. Overdraft fees are generally a fixed amount – typically $20-$40 – so they are sometimes disproportionate to the cost of the item purchased . Banks make huge amounts of money on these fees. According to Moebs Services, in 2009 the fees generated $37.1 billion dollars, with an average fee of $27 on an average purchase of just $16. 2009 is a relevant benchmark, because that was the last year where banks could automatically enroll their customers in overdraft protection, sometimes without the customer's understanding.
An unsuspecting card user can rack up multiple overdraft fees assuming that purchases will be rejected by a vendor if there are insufficient funds in the account, and that, if they are not rejected, things are all right. Meanwhile, banks maximize fees through other methods, such as rearranging the order of the overdrafted transactions from largest to smallest – enacting the overdraft earlier in the list of purchases and racking up more overdraft fees through more total transactions.
In 2009, the Federal Reserve issued new rules that required consumers to opt-in to overdraft protection programs on ATM and point-of-sale transactions (such as retail card swipes). This alleviates some of the problem, but does not cover transactions with traditional checks or recurring scheduled payments using ACH (Automated Clearing House) transfers. These can still overdraw your account, causing those to be returned for insufficient funds (and incur fees) while your ATM and POS transactions are subsequently denied for lack of funds.
What was the overall effect? A June 2013 report by the Consumer Finance Protection Bureau (CFPB) determined that opting in to overdraft protection put consumers at an overall greater risk. CFPB studied customers that were previously prone to overdrafts and found that those who opted out reduced their collective fees by an average of $450 over those who opted in. Involuntary account closures were also higher among those who opted in (through persistent negative balances).
Even so, a significant number of people continue to opt-in, either out of pure convenience or assuming that overdraft protection is a short-term loan by the bank preferable to a payday loan – although for smaller overdrafts, the disproportionate fees probably make a payday loan a better option.
If you do opt-in for overdraft protection, make sure that you understand the fee schedule, posting methods, and how the coverage limits are set. Some banks make this intentionally difficult to follow. If a bank cannot give you an acceptable answer, consider taking your business elsewhere.
Banks do not often publicize it, but some will allow you to opt out of all overdraft protection. In this case, check the size of the insufficient funds fee relative to the overdraft protection transaction fee.
Programs will vary by bank, but these are typical options:
- Opt-in to all Overdraft Protection – As long as you do not go past the overdraft protection limit, you will be charged an overdraft fee for each overdrafted transaction and no NSF fees. Beyond the protection limit, you will probably be charged both NSF fees and overdraft fees per transaction.
- Standard Opt-Out – Point-of-sale and ATM transactions are rejected, with no NSF fees or overdraft fees charged. Checks and ACH electronic transfers follow the same rules as above, since those are still overdraft-protected.
- Complete Opt-out (if available) – Same as standard opt-out, except that all checks and ACH transfers are returned for insufficient funds and NSF fees will apply.
As an alternative to this type of overdraft protection, many banks allow you to link to a secondary checking or savings account at their institution to cover overdrafts – or even to a credit card. There may be transaction fees associated with this service, but they should be lower than typical overdraft or insufficient funds fees.
The only way to tell if a program is right for you is to look at the fees that occur with and without the protection – taking into account any signup fees, the difference between overdraft fees and NSF fees and when they apply, the costs from vendors associated with any rejected bills, as well as any interest that may be charged or other associated fees.
In summary, if you are generally responsible and rarely if ever overdrawn, overdraft protection may be sensible for you to prevent that one overdrafted bill from causing you extra problems. If you are chronically overdrawn, overdraft protection is more of an enabler that keeps you from addressing the real issues of spending and money management. Use it if you feel you have to, but take a hard look at the costs, and get to the real root of the problem. Control your spending to the point where you can afford to keep a cushion in your account to avoid overdrafts, and remember to check your account regularly.