What Is Overdraft Protection?

Overdraft protection is an option offered in bank accounts that prevents check, ATM, or debit card transactions, as well as wire and electronic transfers, to cause a user’s account balance to fall below zero, thereby triggering an overdraft fee or a non-sufficient funds (NSF) fee.

With an overdraft fee, the bank covers the shortfall and charges for the service with the fee, so the transaction goes through successfully, which is why it is also knows as a “courtesy fee.” With an NSF, the transaction is not covered by the bank. Non-preauthorized transactions made with a check and ACH withdrawals are returned unpaid, a practice known as “bouncing.” Most banks charge hefty overdraft fees and NSFs (between $30 and $35 is the average) for accounts that do not have sufficient funds.

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.

Why Use Overdraft Protection?

Non-sufficient funds (or insufficient funds) transactions can be expensive and disruptive. Not only can the bank refuse payment and charge the account holder an NSF fee; a penalty or fee may also be charged by the merchant for the failed transaction. If you bounce a check, you can incur a variety of charges or, in extreme cases, see your bank close your account, hurting your chance of opening a new checking account.

Customers who choose overdraft protection can link their checking accounts to credit cards, savings accounts, or other lines of credit to avoid triggering an overdraft fee or an NSF. This amounts to a preapproved loan or transfer that kicks in automatically when a customer writes a check, makes a wire transfer, swipes a debit card, or asks an ATM for a sum of money in excess of an account’s balance.

Overdraft protection, sometimes called “cash reserve checking,” is most frequently used as a cushion for checking accounts, but it can be applied to savings accounts as well. Banks have the right to reject loans or fund transfers if they fall outside the rules of the overdraft protection agreement.

Bank customers can opt in or out of overdraft protection for their checking or savings accounts.

How Overdraft Protection Works

Typically, an overdraft protection agreement kicks in when an account holder withdraws more than the current balance in a checking account. In that case the individual or business with a linked account is charged a transfer fee to facilitate moving funds to cover the shortfall. The account holder may be also be charged an additional fee every month that overdraft protection is used or a fixed monthly fee for continuous protection.

In the absence of overdraft protection, it is not uncommon for banks to charge multiple overdraft fees or NSFs per day, such as when a consumer makes successive purchases without realizing that the amount in his or her account is insufficient to pay for them. Many banks also charge an extended overdraft fee if a checking account goes negative for more than a few days. It’s important to note that even if an account holder has overdraft protection, banks will still charge this additional fee.

Example of Overdraft Protection

A renter with overdraft protection and a linked account writes an $800 check to cover the monthly rent on an account that only has $650 in it. Instead of bouncing the check due to insufficient funds, the renter’s overdraft protection kicks in when the check is cashed.

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

Special Considerations

Overdraft protection lines of credit can range from $250 to $5,000 and above and, of course, come with an interest rate. If a credit card is used, it should be noted that the amount is treated as a cash advance. This has no grace period and usually incurs a high interest rate, as well as a cash advance fee (usually a $10 flat fee or 5% of the advance, whichever is greater), making it a fairly expensive form of overdraft protection. A linked savings account is probably the least expensive solution, but of course it has to have enough money in it to cover the needed funds.

Overdraft Protection Trends

As of 2017 the median overdraft fee was $34 among the 50 largest U.S. retail banks (by deposits) according to the CFPB. Smaller institutions and credit unions tend to charge less (a median of $31), and some banks, such as online banks, do not charge any overdraft fees. The most common overdraft fee is $35. Many consider overdraft fees abusive, but In the short term banks are unlikely to address them, because, as of mid-2018, CFPB Acting Director Mick Mulvaney halted rule-making plans to reform them.