What is 'Overdraft Protection'

Overdraft protection is a line of credit that banks offer to their customers to cover their overdrafts. Overdraft protection kicks in when a customer writes a check for more than the amount in their account.

Overdraft protection is usually used as a cushion for checking accounts, but can be applied to savings accounts as well.

Also referred to as "cash reserve checking."

BREAKING DOWN 'Overdraft Protection'

Normally, an overdraft occurs when an account holder withdraws more than he has from his checking account. When this happens, the individual or business is charged an NSF fee (Non-sufficient Funds) or overdraft fee which averages $35 per transaction. For example, an individual who writes a check to his landlord for $800 to cover his rent for the month, will have the check bounced if he only has $650 in his checking account. In addition, he will be charged an overdraft fee of, say $30, for approving a debit transaction that exceeds his available funds. Not only will he be penalized by his landlord, he will now have an available balance in his account of $650 - $30 = $620.

An account holder who wishes to protect himself in the event that he runs short of funds at some time in the future, may opt for an overdraft protection. An overdraft protection is, in effect, a loan that can be automatically drawn upon if an account has insufficient funds. Following our tenant example above, if the tenant had secured an overdraft protection with his bank, he can withdraw the sum of his available balance and the overdraft limit. For example, if his overdraft is $500, the tenant can write a check for up to $650 + $500 = $1,150. The $800 check written to his landlord will clear, and he can use his debit card to withdraw an additional $350 from his checking account.

Overdraft protection comes at a price. Like every loan gotten from a bank, overdraft protection has an interest rate attached to it, which is very high. Although the bank allows its customers to avoid paying overdraft fees, it charges interest on the amount floated to them. Given that many banks charge an extended overdraft fee if a checking account has been negative for a certain period of time, interest payments made on time will usually be less expensive than an overdraft or NSF fee. It is important to note that even if an account holder has overdraft protection, some banks still charge him or her if his or her account balance falls below zero.

Banks offer overdraft protection for their customers in the range of $250 to $5,000. Depending on the bank, the account holder may be charged a one-time fee every month s/he goes into overdraft or a fixed monthly fee for continuous overdraft protection.

As an alternative to a line of credit overdraft protection, many banks allow their customers to link their bank accounts to a credit card or another account within the same bank in order to avoid overdraft charges. However, note that a credit card transfer that is used to cover overdraft is treated as a cash advance. Cash advances against a credit card have no grace periods, and incur higher interest rates and a cash advance fee, making this form of overdraft protection very expensive.

Overdraft protection is optional and not for everyone. Bank customers can opt in or out of overdraft protection for their checking or savings accounts. A customer that opts out of overdraft coverage will have debit transactions either from an ATM, POS terminal, or check, declined if the transaction amount exceeds the available funds in the account.



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