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What is an 'Overdraft'

An overdraft is an extension of credit from a lending institution when an account reaches zero. An overdraft allows the individual to continue withdrawing money even if the account has no funds in it or not enough to cover the withdrawal. Basically, overdraft means that the bank allows customers to borrow a set amount of money.

BREAKING DOWN 'Overdraft'

With an overdraft account, your bank covers checks that would otherwise bounce and get returned without payment. As with any loan, you pay interest on the outstanding balance of an overdraft loan. Often, the interest on the loan is lower than credit cards. In many cases, there are additional fees for using overdraft protection that reduce the amount available for overdraft protection, such as insufficient funds fees per check or withdrawal.

Overdraft and Your Credit Score

Your bank can opt to use its own funds to cover your overdraft. Another option is to link the overdraft to a credit card. If the bank uses its own funds to cover your overdraft, then it typically won't affect your credit score. When a credit card is used for the overdraft protection, it's possible that you can increase your debt to the point where it could affect your credit score. However, this won't show up as a problem with overdrafts on your checking accounts.

If you don't pay your overdrafts back in a predetermined amount of time, your bank can turn your account over to a collection agency. This collection action can affect your credit score and get reported to the three main credit agencies. It depends on how the account is reported to the agencies as to whether it shows up as a problem with an overdraft on a checking account.

Overdraft Protection as a Useful Tool

Overdraft protection provides you with a valuable tool to manage your checking account. If you forget to take out money for a trip to Starbucks, overdraft protection ensures that you don't have a check returned and reflect poorly on your ability to pay. However, banks charge a fee and make money from this service; make sure you use the overdraft protection sparingly and only in an emergency situation.

The dollar amount of overdraft protection varies by account and by bank. In some cases, the customer needs to request the addition of overdraft protection. If the overdraft protection is used excessively, the financial institution can remove the protection from the account.

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