If you’ve ever overdrawn your checking account, you know how painful those overdraft fees can be. How can you avoid paying exorbitant fees 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.

Key Takeaways

  • Overdraft protection is a service your bank provides that pays for things you buy after your account goes below $0 into a negative balance.
  • The most common form of overdraft protection is a revolving credit limit attached to your bank account.
  • Since overdraft is a fee-based service, banks can charge high fees and interest to clients who use it.
  • Other types of overdraft including linked accounts or overdraft lines of credit.

Protect Yourself

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 either using the wrong account, your recent deposit hasn’t gone through yet, or you simply misjudged the amount of money in your checking account. And guess what? Each of these cases can be the tipping point that puts your account into the red.

The best way to avoid overdraft fees is simple: Avoid overdrawing your account. These days, online banking has made avoiding overdraft easier than ever. You can get an email or phone alert whenever you cross a low-balance threshold. You can then transfer funds before a pending transaction puts you below the $0 mark. If you're not really that tech-savvy, make sure you whip out the trusty old check register to keep tabs on your spending. 

But like we said earlier, sometimes you just can't help it. If you do overdraw your account, 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 your bank provides that pays for things you buy after your account goes below $0 into a negative balance. It means any checks you write against your account won't bounce and your debit transactions will still go through—even if you don’t have any money in your checking account.

Overdraft protection began when banks had the discretion to extend preferred customers the courtesy of paying for their items when they didn't have enough funds to cover these transactions. This service eventually went from being a generous courtesy on the part of banks to a lucrative financial service offered to just about anyone. In fact, there are several major types of protection available today.

Types of Overdraft Protection

The most common form of overdraft protection is based on your credit score. The bank runs a credit check to determine a suitable credit limit. If you're approved, the bank adds the service to your bank account. Like a credit card, this limit is revolving, which means you can use any amount up to the limit. In essence, it acts as a short-term or temporary loan, so if you need to dip down below $0 into a negative amount to cover an unexpected expense, you won't have to forgo your other obligations. For instance, you don't have to worry about your regular mortgage payment being returned because you wrote a big check to cover that unexpected dishwasher repair.

Like any other credit product, overdraft protection is at the discretion of the bank. This means the bank can approve and cancel the service at any given moment. If you don't repay the balance and continuously maintain a negative balance, the bank may decide to close the account and collect on the balance. In most cases, interest continues to accrue.

While overdraft protection can provide some peace of mind in an emergency, it's important to remember that it is a fee-based service. Most banks charge you a regular monthly fee to have the service on your account and because it's considered a short-term loan, they usually charge interest on the average overdrawn balance each month. Keep in mind, you are responsible for any negative balance, which means you have to bring the account back into the black.

Weigh out the benefits of having overdraft versus the fees you'll end up paying for using the service.

Linked Savings Accounts

There is a way to avoid overdraft fees and still give yourself worry-free banking. Talk to your bank about linking your checking and savings accounts together. When you overspend with your checking account, the bank will cover the shortfall from your linked account to keep you from going into the red. This is often the best type of overdraft protection because you avoid paying high overdraft fees and interest.

Your savings account needs a pretty decent balance for this to work. And although there aren't any overdraft fees involved, you may incur a transfer or withdrawal fee every time it kicks in. These charges are fairly typical for savings accounts. It's a good idea to check with your financial institution about its transfer procedures and fees.

Overdraft Line of Credit

A similar kind of protection is the overdraft line of credit. Instead of having a savings account linked to your checking account, the bank links 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. These facilities are not as popular though.

Credit Score Implications

Overdraft protection can affect your credit score. 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. If you use an overdraft line of credit or linked credit card, keep in mind the potential negative consequences of having that extra money on your card—especially if you're the type of person who has a tough time repaying the balance.

Criticism of Overdraft Protection

Overdraft protection can certainly be a saving grace when you need some extra cash in a pinch. But it's a very controversial financial product. That's because banks are often able to skirt usury laws with overdraft fees, even though many people feel that overdraft protection is a loan. Loans are governed by the Truth in Lending Act (TILA) of 1968. But because overdraft protection is considered a fee-based service rather than a loan, it's not covered. This means 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. So while you may be able to rely on it from time to time, it should be used as an insurance policy in emergency cases only and not for everyday use.

The Bottom Line

If you are hit with overdraft fees for linked-account or bounce protection, the easiest way to avoid having to pay is to call your bank and ask. If you’ve been a customer in good standing for a while and this is your first or second time overdrawing, it’s likely your bank will let you off the hook.

Of course, the best choice is to 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 pays to have decided in advance which kind of overdraft protection is the most beneficial for you.