What Is an Overdraft?

An overdraft is an extension of credit from a lending institution that is granted when an account reaches zero. The overdraft allows the account holder to continue withdrawing money even when the account has no funds in it or has insufficient funds to cover the amount of the withdrawal.

Basically, overdraft means that the bank allows customers to borrow a set amount of money. There is interest on the loan, and there is typically a fee per overdraft. At many banks, this fee is around $35.

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Overdraft

Understanding an Overdraft

With an overdraft account, a bank is covering payments a customer has made that would otherwise be rejected, or in the case of actual checks, would bounce and be returned without payment.

As with any loan, the borrower pays interest on the outstanding balance of an overdraft loan. Often, the interest on the loan is lower than the interest on credit cards, making the overdraft a better short-term option in an emergency. In many cases, there are additional fees for using overdraft protection that reduce the amount available to cover your checks, such as insufficient funds fees per check or withdrawal.

[Important: Like other loans, overdrafts have interest and fees, and as such, customers should only use the loans in an emergency, when no other funds are available.]

How Overdraft Protection Works

Overdraft protection provides the customer with a valuable tool to manage their checking account. If you're short a few dollars on your rent payment, overdraft protection ensures that you won't have a check returned against insufficient funds, which would reflect poorly on your ability to pay. However, banks provide the service because of how they benefit from it—namely, by charging a fee. As such, customers should be sure to use the overdraft protection sparingly and only in an emergency.

The dollar amount of overdraft protection varies by account and by the bank. There are pros and cons to using overdraft protection. Often, 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.

Special Considerations

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, 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 over your account to a collection agency. This collection action can affect your credit score and get reported to the three main credit agencies: Equifax, Experian, and TransUnion. 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.

Key Takeaways

  • Overdraft protection is a loan provided by banks to customers when their account reaches zero.
  • The overdraft allows the customer to continue paying bills even when there is insufficient money in the customer's account(s).
  • Like with any other loan, the customer pays interest on the loan and, in the case of overdrafts, will typically have a one-time insufficient funds fee.