What Is Overdraft Protection? How It Works and Do You Need It

What Is Overdraft Protection?

Overdraft protection is an optional service that prevents the rejection of charges to a bank account (primarily checks, ATM transactions, debit-card charges) that are in excess of the available funds in the account. Overdraft protection, sometimes called cash-reserve checking, is used most frequently as a cushion for checking accounts, but it also can be applied to savings accounts.

With overdraft protection, even if the account has insufficient funds, the bank will cover the shortfall so that the transaction goes through. When a customer signs up for overdraft protection, they designate a backup account for the bank to use as the source to cover any overdrafts—usually a linked savings account, credit card, or line of credit. However, the bank charges the customer for this service in a few ways, e.g., overdraft fees to process any transactions that overdraw the account.

Key Takeaways

  • Overdraft protection is a guarantee that a check, ATM, wire transfer, or debit card transaction will clear if the account balance falls below zero.
  • There may be heavy fees and interest associated with overdraft protection, depending on the kind of linked account used.
  • Overdraft protection lines of credit can range from $250 to $5,000 and above.

How Overdraft Protection Works

Without overdraft protection, transactions that have insufficient funds to cover them are returned unpaid—that is, checks bounce and debit transactions are refused, which can be expensive and disruptive for the customer. Most banks charge hefty overdraft and non-sufficient funds (NSF) fees (between $30 and $35, per transaction, on average) for accounts that do not have sufficient funds. What's more, not only can the bank refuse payment and charge the account holder, but a penalty or fee may also be charged by the merchant for the failed transaction.

To avoid overdraft and NSF fees, customers who choose overdraft protection link their checking accounts to credit cards, savings accounts, or other lines of credit that kick in whenever they withdraw more than the current balance. This amounts to an automatic, pre-approved loan or transfer every time the customer with insufficient funds writes a check, makes a wire transfer, swipes a debit card, or asks an ATM for a sum in excess of the balance.

As soon as the overdraft protection service is triggered, the linked account is charged a transfer fee to move funds to cover the shortfall. The account holder may also be charged either an additional fee every month that overdraft protection is used or a fixed monthly fee for continuous protection.

Bounced Check Penalties

If you bounce a check, you can incur a variety of charges or, in extreme cases, your bank can close your account, which also impacts your ability to open a new checking account.

Example of Overdraft Protection

If a renter with overdraft protection writes an $800 check on an account with a balance of $650, the overdraft protection from their linked account kicks in as soon as the check is cashed—and the check clears instead of bouncing due to insufficient funds.

The bank charges a transfer fee of $15 for approving a transaction that exceeds available funds. The renter will now have a balance of $635 ($650 - $15) in the account as well as a charge of $800 to pay off on the linked credit card, line of credit, or savings account.

Multiple Overdraft or NSF Fees

In the absence of overdraft protection, it is not uncommon for banks to charge multiple overdraft or NSF fees per day. For example, a consumer might make successive purchases without realizing that the amount in their account is insufficient to cover the charges. If a checking account goes negative for more than a few days, many banks also charge an extended overdraft fee. It’s important to note that—even if you have overdraft protection—banks can still charge this additional fee.

Special Considerations

Lines of credit for overdraft protection can range from $250 to $5,000 and above—and, of course, customers incur interest charges and transaction fees for using these lines.

If a credit card is used as the backup account, the amount is treated as a cash advance—which can be an expensive form of overdraft protection. Not only do cash advances have no grace period, but they also have high interest rates and high fees (usually $10 flat fees or 5% of the advance, whichever is greater).

A linked savings account is probably the least expensive backup account for overdraft protection, but the backup must hold enough money to cover the shortfall in the first account.

Trends in Overdraft Protection

Overdraft fees have always been among the most controversial bank fees. According to a BankRate.com survey of 245 banks and thrifts in 25 large U.S. markets, the average overdraft fee declined to a 13-year low of $29.80, which is down 11% over last year’s record high of $33.58.

In the wake of the 2020 pandemic, public debate accelerated a trend toward eliminating overdraft fees altogether. For example, the U.S. Senate held hearings on how and why banks charge fees for insufficient funds and criticized bank CEOs for refusing to halt overdraft fees during the pandemic.

More evidence of this trend includes a 2022 American Banker report that—as big banks made headlines for reducing or eliminating overdraft fees—even credit unions felt pressure from regulators and digital bank competitors to do the same.

Is There a Limit on Overdraft Fees?

Federal laws do not specify maximums that banks can charge for overdrafts, but banks are required to disclose any fees when the account is established—and they are required to give customers advance notice of any fee increase.

Can Banks Refuse to Cover Overdrafts?

Banks are not required to offer overdraft protection, and—even when they do and a customer opts in—they retain the right to pay or not pay a particular overdraft transaction that might fall outside the rules of the agreement.

Is Overdraft Protection Mandatory?

Overdraft protection is optional; it is only the service that is automatic for bank customers who choose to opt in for overdraft protection on their checking or savings accounts.

Article Sources
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  1. Consumer Financial Protection Bureau. “Overdraft & NSF Metrics for Top 20 Banks.”

  2. Bankrate. “Survey: Free Checking Accounts on the Rise as Total ATM Fees Fall.”

  3. American Banker. “Pressure Mounts on Credit Unions to Cut Overdraft Fees.”

  4. The Office of the Comptroller of the Currency. “Is There a Limit on Overdraft Fees?

  5. The Office of the Comptroller of the Currency. “What Is Overdraft Protection?

  6. Consumer Financial Protection Bureau. "Understanding the Overdraft 'Opt-in' Choice."

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