When you walk into your local bank or credit union to open a checking account, the staff will no doubt recommend a variety of additional financial services. However, this is not merely a matter of offering better, and more extensive, services for their customers. True, it's in the bank's best interest to provide a full range of financial products and services in order to attract, and maintain, a healthy clientele. But these services are also a major source of income, and when it comes down to it your bank is usually thinking more about their bottom line than they are about yours.
One of the services you will be encouraged to sign on for is 'Overdraft Protection', a popular feature attached to many mid-tier and upper-tier checking accounts. Overdraft protection offers some very real benefits to the customer, but those benefits come at a cost. Before you opt-in to an overdraft protection plan, it is important to fully understand the program and the potential pitfalls.
What is an Overdraft?
An overdraft occurs when you write a check, make a debit card purchase, or authorize an automatic bill payment for an amount of money that exceeds the current balance of your checking or savings account. In effect, an overdraft takes your account into a negative balance, leading to checks being returned and transactions being refused due to 'non-sufficient funds' (NSF).
You, Your Bank, and Overdrafts
There are three basic ways in which a bank may treat an overdraft – No Protection, Overdraft Forgiveness, and Overdraft Protection. 'No Protection' is the default position for most banks, and while you may be offered overdraft forgiveness or protection, it is up to you whether or not you sign on for the service. To help you make your decisions, a brief overview of each method is in order.
- No Protection – Banks do not allow checking or savings accounts to move into the negative, and any transaction that exceeds your current account balance will be refused, and you will be charged a fee. This fee is typically called an 'insufficient funds fee' or a 'returned item fee', and can cost upwards of $35 to $45 depending on the bank or credit union. Of course, you will also face fees from the vendor or debtor to whom you wrote the check. Those fees are governed by state law, and can range from a flat fee of $30 to $50 or 10% of the total amount of the check, whichever is greater. Unlike checks, debit card purchases can not result in an overdraft scenario. If a debit card transaction exceeds the balance in your account, it will be denied at the point of purchase and no overdraft fees can be attached.
- Overdraft Forgiveness – With overdraft forgiveness, your bank will cover any transaction that takes your account into a negative balance. In effect, your bank is lending you the necessary funds to avoid going into the red. While this prevents you from bouncing checks, you are still charged the full overdraft fee as set by your bank. In addition, the bank may charge interest on the amount of money it is 'lending' you, over and above the overdraft fees. Overdraft forgiveness applies to both check and debit transactions, and the costs can quickly add up if you do not manage your accounts wisely. Customers must op-in to an overdraft forgiveness program, and banks are required by law to fully disclose how overdraft transactions and fees are handled.
- Overdraft Protection – Overdraft protection should not be confused with overdraft forgiveness. With overdraft protection, your primary checking account is linked with a savings account or a credit card, allowing your bank to transfer funds as needed to prevent your account from moving into the negative. Overdraft protection can be very beneficial, but it too comes with some risks. Even though your bank is using your own money to cover any transactions, they still charge a fee for the service. This fee is substantially lower than standard overdraft charges (typically $10 to $15), but can still add up if you are prone to over-drafting your account. It's also worth noting that if you choose to link your overdraft protection to a Visa or MasterCard, you will have to contend with the fees and charges associated with a cash advance from a major credit card. There are also limits to the number of times you can utilize overdraft protection before you are penalized by your bank. Again, you must opt-in to the program to be covered by overdraft protection, and your bank must fully disclose how your transactions will be handled and how the fees will be assessed.
In 2013 a Pew Charitable Trust study found that 10% of adults with checking accounts paid at least one overdraft fee & another 5% paid and overdraft transfer fee. These penalties amounted to an estimated $32 billion in fees in 2012. Consumers who plan their budgets and create a safety fund can easily avoid these expensive fees.
Understanding the Two Basic Models
When you enroll in overdraft protection, your bank will use one of two methods when transferring funds from a secondary account to your primary checking account. Each has its advantages and disadvantages, and it's worth noting the differences between the two policies if you are going to make an informed decision about whether or not to opt-in to an overdraft protection plan.
- The 'Just Enough' Model – A 'just enough' overdraft policy means that your bank will transfer just enough funds from your secondary account to prevent your checking account from moving into the negative. So, for example, if you write a $50 check and you only have $20 in your checking account, your bank will transfer $30 from your linked account to cover the transaction and you will be charged a one time fee for the transfer of funds. On the one hand, this keeps a limit on the amount of funds pulled from your secondary account, ensuring that its balance is protected. However, this method puts your checking account at a balance of $0, leaving you without a buffer against any further overdrafts. Until you make a deposit into your checking account, or formally transfer funds from a savings or money market account, you are still at risk for further overdraft transactions and the fees that accompany them.
- The 'Incremental' Model – With an 'incremental' overdraft policy, your bank transfers funds from your linked account to your checking account in predetermined amounts. Naturally, your bank will have to make as many transfers as necessary to cover the overdraft and return your checking account to a positive balance. For example, if your bank offers incremental overdraft protection in $50 amounts, and you overdraft your checking account by $75, your bank will make two transfers of $50 each for a total of $100. This leaves a buffer in your checking account, protecting you from another overdraft, but it also puts a greater drain on your secondary linked account. Moreover, most banks will charge for each overdraft transaction. So if your bank charges an overdraft protection transfer fee of $12, and your bank charges for each incremental transfer, a $75 overdraft will cost you $24 in fees.
Banks typically favor one overdraft model, and you may not have a choice in how your overdraft protection plan is managed. Before you sign up for an overdraft protection service it is important that you understand how the necessary transfers will be handled, and how your bank will calculate the transfer fees.
Additional Fees and Charges May Apply
We've already touched on the primary fees associated with overdraft protection. These are the fees your bank charges each time they transfer funds from your linked source to cover an overdraft. However, there are some additional fees and charges you should be aware of before you opt-in to an overdraft protection plan.
- Set-Up Fees – Some banks charge an initial set-up fee when you sign on for overdraft protection.
- Recurring Fees – Some banks charge an annual or monthly fee for overdraft protection. This is particularly common when your overdraft protection is linked to a line of credit as opposed to a savings account.
- Insufficient Funds Fee – If your linked account does not contain enough funds to cover your overdraft, your bank will ignore the 'protecting' account and charge you an insufficient funds fee. This is an important point, particularly if your overdraft protection plan follows the incremental model. For example, let's say you overdraft your checking account by $12, but you have $30 in your linked account. If your overdraft protection plan is set up to transfer funds in increments of $50, there will not be enough money in your linked account to complete the transaction. Your check will bounce and you will be charged an insufficient funds fee.
- Excessive Transaction Fees – Federal law limits the number of transfers or withdrawals from a customer's savings account to six transactions per month, after which they must pay a penalty fee. Some banks restrict this even further, limiting the number of transfers to three. If you hit this limit and still need an overdraft protection transfer, your bank may either reject the transfer and charge you an insufficient funds fee, or allow the transfer while charging you an additional excessive transaction or excessive withdrawal fee.
These additional charges vary from bank to bank, so it is vital that you fully understand how your bank manages its overdraft protection services before you sign up for the program. Fortunately, Federal law requires that all banks and credit unions fully disclose how their overdraft protection services are managed, and how fees are assessed and applied. However, it is up to you as a customer to read the fine print.
The Pros and Cons of Overdraft Protection
The chief advantage of signing on for overdraft protection is that your checking account will never slip into a negative balance. Your checks will never bounce and your debit card transactions will never be rejected (assuming, of course, that you do not overtax your linked accounts). This can be more than simply a convenience, particularly in an emergency; and while overdraft protection comes with a price, that cost is usually significantly cheaper than racking up fees for non-sufficient funds (NSF) and returned checks. Moreover, when it comes to bouncing checks there's more to consider than just the financial ramifications, which in themselves can be significant. The party you wrote the bad check to can not only charge you a returned check fee, they can also report you to a consumer credit reporting agency like ChexSystems. This can lead to vendors refusing your checks, banks refusing to allow you to open new accounts, and your current accounts being frozen or terminated.
While there are many advantages to having overdraft protection, there is a downside. The ways in which banks order transactions and determine overdraft fees can be confusing to the layman, and it can be hard to predict when and how overdraft fees will be imposed. This can lead to excessive fees that negate the value of having an overdraft protection plan in place. Overdraft protection also makes it all too easy to mismanage your money. Without overdraft protection, you are forced to pay stricter attention to your bank balance if you want to avoid bouncing checks or having your debit card transactions rejected. The fear of a negative balance helps to keep spending in check, while the convenience of overdraft protection can adversely impact your ability to save money and live within your means.
Overdraft Protection is Your Choice
Federal guidelines restrict banks from enrolling customers in overdraft protection plans without their express consent. Banks must fully disclose all aspects of their overdraft protection services, including all associated fees, charges and penalties, before the customer enrolls in the program. Customers also have the right to opt out of an overdraft protection plan at any time, without fear of penalty or reprisal. Remember, banks profit significantly from overdraft fees, and it is your right as a consumer to opt-in, or opt out, of any overdraft protection plan as you see fit.
Protecting Yourself from Excessive Overdraft Fees
In the final analysis, the most effective overdraft protection is you. Knowing how to manage your money, and keeping a watchful eye on your bank balance, will help to keep your accounts from slipping into the red. However, should you decide to opt-in to your bank's overdraft protection service, there are a few things you can do to avoid falling prey to excessive overdraft fees.
- Use Cash – Give yourself a weekly cash allowance, and avoid using a check or debit card to pay for everyday purchases. This not only helps you avoid unexpected overdraft fees, but studies have shown that when people pay in cash they are less likely to overspend.
- Balance Your Check Book Regularly – The best way to avoid a negative balance and subsequent overdraft fees is to keep track of your spending. When you write a check or make a purchase using your debit card, make it a point to promptly balance your check book. This will ensure that you always know how much money is in your account, and will prevent you from any unnecessary overdraft fees.
- Set Up Text Alerts – Many banks will allow you to set up text alerts notifying you when your bank balance drops to a certain level. This is particularly useful if you have opted for automatic billing or withdrawals on recurring monthly expenses.
- Understand the Difference Between Your Available Balance and Your Total Balance – Deposits often take a day or two to post in your account. The same holds true for withdrawals and debits. Consequently, at any time your available balance may be less than your total balance, and confusing the two can lead to an unexpected overdraft. Always refer to your available balance when deciding whether or not you have enough money in the bank to cover a check or debit card purchase.
These basic tips really apply to everyone, regardless or whether or not you are enrolled in an overdraft protection plan. Following these rules will help you to avoid bouncing checks, or having your debit card purchases rejected for lack of funds. However, if you have signed on for an overdraft protection plan, these tips will help minimize your risk for any unexpected, or excessive, overdraft fees.
Overdraft protection can be a valuable service, particularly in an emergency. But make no mistake, banks do not offer overdraft protection merely as a courtesy to their customers. Banks are ever mindful of their own bottom lines, and overdraft fees are a significant source of their income. They're happy to offer overdraft protection services, because each transaction means more money in their coffers. Before you enroll in your bank's overdraft protection plan, be certain that you understand what you are signing on for. Read the contract fully, paying close attention to the small print. Take nothing at face value, and ask your bank's representative to explain any part of the program that you find confusing. Remember, overdraft protection can be a valuable service, but it can also easily lead to excessive fees that put your own bottom line at risk.