Both overdraft protection and credit cards are, essentially, personal lines of credit. They advance you money which you must repay, often with interest.
In general, deciding between overdraft protection or a credit card depends on several factors, such as the fees involved and how you use the available credit.
- Both overdraft protection and a credit card are personal lines of credit—loaning you funds which you must repay with interest.
- Overdraft protection is usually attached to a checking account, ensuring that checks don't get returned for insufficient funds.
- Which works better for you depends on a variety of factors, including the fees involved and how you are using the funds.
How an Overdraft Works
If you have overdraft protection at your bank, you can spend more than the actual amount in your attached checking account. When you do, the check won't bounce. Instead, the bank will honor it—advancing you the amount, in effect. In exchange for this service, you’ll pay the bank interest on the amount by which you overdraw your account.
Some overdraft lines of credit will charge you a fee for each overdraft, and some have annual fees instead of, or in addition to, overdraft fees. Since an overdraft basically establishes a personal line of credit, the amount the bank will let you borrow will depend to some extent on your creditworthiness, as well as the bank's own policies.
Both overdraft lines of credit and credit cards often carry late-payment penalties. So whichever option you choose, be sure to make your payments on time.
How a Credit Card Works
A credit card also functions as a line of credit, specifically a revolving line of credit (meaning it is flexible and open-ended, as opposed to a finite loan that must be repaid within a certain period). That line is as big as your credit limit—that is, how much you can charge on the card.
Whenever you use a credit card, you are basically borrowing funds from the credit card company to buy goods or services. When you get your monthly statement, you then repay the company for the money it advanced you.
Now, if you borrow funds by making purchases with the card, and you can’t immediately repay that amount in full—if you start carrying an outstanding balance from month to month, in other words—you’ll also be charged interest on that amount. Credit card interest rates can vary significantly depending on the card and your credit score. Many credit cards also charge annual fees.
Overdraft vs. Credit Cards: Which to Use?
Choosing between overdraft protection or a credit card depends on several factors:
- Do you have access to both options?
- Do both options give you enough available credit to cover the amount you need to borrow?
- Which one has a lower interest rate?
- Is there an overdraft fee when you use the overdraft line of credit?
- Does either option charge an annual fee?
You’ll have to do the math for your specific situation to see which choice is less expensive.
An Example of Overdraft vs. Credit Card
Suppose you need $1,200 for car repairs. Although you only have $200 in your account, you write the garage a check for the whole amount. Through an overdraft line of credit, your bank will let you borrow the money at 18% annually (assuming no compounding, interest paid annually) and pay a $12.50 overdraft fee. If you want to pay the loan back within a year, you’ll need to pay a total of $180 in interest plus $12.50 in fees.
Through a credit card, you can borrow the money at an introductory rate of 12% for one year (assuming no compounding, interest paid annually), and the card has no annual fee. You’ll need to pay $144 in interest.
In this case, the credit card is the better choice. Of course, if the credit card charged you a higher annual percentage rate (APR) and/or an annual fee, the advantage might go to the overdraft.
The Bottom Line
Both overdraft protection and credit cards have their pros and cons, and generalizing which is better in every situation is impossible. Typically, though, credit cards work better for planned or predictable expenses that you intend to pay off over time.
Overdrafts work best in emergency situations, saving you the embarrassment and hassle of a check being rejected for insufficient funds.