If you've ever overdrawn your checking account, you know how painful those overdraft fees can be. How can you avoid paying out big time when you overspend? Banks offer a few types of overdraft protection that can keep you fee-free, but don't think that they're all created equal. Here's what you need to know to make sure that your overdraft plan isn't overblown.
Overdrafts happen. You don't have to be a deadbeat to write a check or buy something with a debit card only to find that you're using the wrong account, your deposit hasn't gone through yet, or you simply misjudged the amount of money you have in your checking account. And guess what, each of those cases can be the tipping point that drops your account into the red.
Plain and simple, the best way to avoid overdraft fees is to avoid overdrawing your account. These days, electronic banking has made overdraft avoidance easier than ever - you can get email or phone alerts whenever you cross a low balance threshold, you can transfer funds before a pending transaction puts you below the $0 mark, and even the trusty old check register is still around as a means of keeping tabs on your spending. (For more information, read How does online banking assist with budgeting?)
However, if you do overdraw, there are a few things you can do to keep things from spiraling out of control.
What Is Overdraft Protection?
Overdraft protection is a service provided by your bank that pays for things you buy after you've overdrawn your account. It means you'll avoid bounced checks, and your debit transactions will still go through even if you don't have any money in your checking account.
Overdraft protection saw its start when banks had the discretion to extend preferred customers the courtesy of paying for their items when they had overdrawn their accounts. Well, these days, overdraft protection has made the switch from a generous courtesy on the part of banks to a lucrative financial service; there are several major types of overdraft protection available today.
One thing that makes overdraft protection so controversial is the fact that banks are often able to skirt usury laws for overdraft fees, even though many people feel that overdraft protection is a loan of sorts. Loans are governed by the Truth In Lending Act, but because overdraft protection is seen as a fee-based service rather than a loan, in many cases you could be paying a hefty premium for the right to overdraw your account. You'll see that some kinds of overdraft protection services can be a lot like payday loans. (For more on this, read Payday Loans Don't Pay.)
Types of Overdraft Protection
The simplest type of overdraft protection is linked accounts. With linked accounts, your checking account is connected to another account, such as your savings account. When you overspend with your checking account, the extra money comes out of your savings account to keep you from being in the red. This is often the best type of overdraft protection because you avoid paying the bank to use its money - but there's one caveat: you actually need to have money in another account somewhere to use this. (Note: Banks sometimes charge you a small fee every time your linked account kicks in - make sure yours doesn't, or that you can live with it if it does.)
A similar kind of protection is the overdraft line of credit. With this, your linked account isn't a savings account; it's a line of credit or a credit card. The obvious downside to using an overdraft line of credit is the fact that you're using credit to fuel your purchase. If the linked credit is a credit card, you can also count on paying the cash advance rate for the money you use.
Ad-Hoc, or bounce protection, is a fee-based service where banks use their discretion and can choose to let you overdraw or let the check bounce depending on your status with as a customer; if you've never overdrawn before, they're a lot more likely to cover your purchases than if your account is delinquent. With ad-hoc protection, you're charged a fee (often increasing each time you overdraw) and have to pay the money back to get your account back in good standing. The bad side to ad-hoc is that the fees can sometimes be a lot compared to the amount by which you overdraw. (Check out our article The Ins And Outs Of Bank Fees, to learn more about the bank's service charges.)
Also remember that with bounce protection, you're charged a fee for each time that you have a transaction that overdraws the account - and banks usually order daily transactions in such a way that as many as possible will overdraw. So, if you have $20 in your checking account and you use your debit card for five $2 purchases and a $50 purchase, when those transactions go through, the $50 will be applied before the $2 transactions, and you'll be hit with six overdraft fees.
Credit Score Implications and Getting Out of Overdraft Fees
It's important to remember that overdraft protection can also have an effect on your credit score. (For further information, read The Importance of Your Credit Rating.)
If you have bounce protection and don't bring your account back to good standing soon enough, you can bet that your credit score will take a hit. Also, if you use an overdraft line of credit or linked credit card, keep in mind the effects of having that extra money on your card. (To learn more about keeping a good credit rating, read Five Keys To Unlocking A Better Credit Score.)
If you get hit with overdraft fees for linked account or bounce protection, the easiest way to avoid having to pay is simply to call your bank and ask. It's as simple as that. If you've been a customer in good standing for a while and this is your first or second time overdrawing, it's more likely than not that the bank will let you off the hook.
Of course, the best choice is to just not overdraw your account at all, but this is obviously not the easiest answer for many people. Overdraft protection is a huge moneymaker for banks these days, and they know it. If you are going to overdraw your account, it can pay to have a handle on which kind of overdraft protection is right for you.