What Is Bank Overdraft Protection And How Does It Work?
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Summary:
Bank overdraft protection is a service that you can set up with your checking account. If your transaction exceeds your checking account balance, this service allows you to pull funds from a savings account or credit line and avoid overdraft fees. It might be a useful option if you tend to overspend from your account because it can help avoid overdraft fees. But there are often fees associated with bank overdraft protection too, so it’s a good idea to read the fine print before opting in.
If you’ve ever felt stressed about whether your card will get declined during a transaction, then overdraft protection might be a useful option for you. For a small fee, you can opt in to your financial institution’s overdraft protection service, which will ensure that wire transfers, ATM transactions, or other everyday debit card transactions are never declined.
But is overdraft protection worth the cost? How much money are you really saving by choosing this service? Here’s everything you need to know about how to set up overdraft protection, why you might want it, and what to consider before opting in.
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What is overdraft protection?
Overdraft protection is set up through the financial institution associated with your checking account. The service allows you to set up a system that pulls money from your savings account, credit card, or even a line of credit if you overdraw your checking account.
This ensures that your debit card is never declined. It also means that you won’t have to pay an overdraft fee. That being said, there are usually smaller fees associated with overdraft protection. Because of this, it’s important to understand the fees that are involved with overdraft protection and how different setups might impact your finances.
Example
For example, let’s say you have $500 in your checking account. You go to the store and purchase $100 in groceries, but you forget that you just wrote your landlord a rent check for $400. On top of that, you have recurring debit card transactions charged to your account that equal $200.
Without overdraft protection, your rent check would bounce and your automatic payments would be declined. You may incur late fees or insufficient fund fees on each of these charges. Before you know it, you’ve racked up another $75 in fees.
With overdraft protection (let’s assume through a savings account), all of your payments go through. You’re charged $15 for a transfer fee, but you avoid a negative balance and additional fees.
How do you get overdraft protection?
The process for setting up overdraft protection depends on your bank. However, all banks require that customers “opt-in” to the service. As always, it’s important to understand the specific requirements, fees, and set-up process for your bank.
How to set up overdraft protection
If you need to set up this service, you have a few different options for how to do so. Most banks, especially online banks or credit unions, allow you to set it up online with a few clicks. The most important decisions are whether you want to set it up and which bank account will be your linked account.
The linked account is where the money will be taken when an overdraft occurs. Typically, customers choose to connect a savings account.
IMPORTANT! If you can’t find where to set up overdraft protection online, you can always call your bank to set it up. A customer support representative will be able to talk you through the steps for your checking accounts.
How much is overdraft protection?
The fees associated with overdraft protection vary between institutions and depend on the type of overdraft protection you have in place. If you have a savings account linked to your checking account, the transfer fee usually ranges from $10 to $15 per transaction.
If you have overdraft protection set up with a line of credit or credit card, then there may be additional fees in the form of interest charges. That said, a few dollars in interest charges may be worth avoiding overdraft fees. According to the Federal Deposit Insurance Corporation, the fees are often around $35 per transaction if you overdraw your account and do not have overdraft protection in place.
With this in mind, it’s nice to know that some accounts don’t charge overdraft fees. If you struggling with overdrawing your account and want a checking account with minimum fees, consider some of the accounts below.
Overdraft protection rules
The rules of overdraft protection vary depending on the type of protection you have set up. However, there are a few rules that apply to all of them.
- Money must be paid back. The first rule to keep in mind is that overdraft protection does not provide free money. The money either comes from a linked account you own or is loaned to you from your financial institution or credit card. Regardless of the setup, the money used to cover your purchases or bills must be repaid.
- Understand your protection setup. The second rule to remember is that it’s a good idea to be intentional about your overdraft fee protection setup. Make sure that you understand where the money comes from, how a linked overdraft protection account works, and all associated fees. A few minutes of reading your checking or savings account’s fine print might be able to save you stress and fees down the road.
Depending on the type of overdraft, the fees might also be called non-sufficient fund (NSF) fees.
Pros and cons of overdraft protection
Overdraft protection can be a huge help to anyone worried about accruing fees. However, it’s important to remember that this protection also comes with its fair share of downsides.
Types of overdraft protection
There are a few different types of overdraft protection and the type you have set up will depend on a mixture of your personal preferences and the options available.
Line of credit
Some banks allow customers to open an overdraft line of credit. This usually involves a hard pull on your credit (which will impact your credit score) and functions as other lines of credit in that the money is on loan from the bank.
This type of overdraft requires customers to pay interest on the overdrawn amount until it is paid in full.
Credit card
Some banks allow customers to use credit cards as another overdraft protection option and link that card to their checking account. If the checking account is overdrawn, then the amount is charged to the credit card.
There may be additional fees associated with any overdraft transaction charged to a credit card if it’s an automatic bill payment (ACH transfer).
Linked savings account
Linked accounts tend to be the most common type of overdraft protection. To set it up, customers have a linked savings account added to their checking account. If you overdraw your checking account, then money transfers from the linked savings account to cover the expense. Banks often charge a small transfer fee for the service.
Is overdraft protection worth it?
Whether overdraft protection is a good idea really depends on your needs and spending habits. Some people benefit from this service because it allows them to avoid embarrassing situations (like declined cards).
It can also save on potential fees. In fact, research shows that up to two-thirds of annual bank revenue comes from overdraft fees and non-sufficient funds penalties, so it helps your wallet if you can avoid extra fees. But for others, overdraft protection can lead to overspending, especially if the debit card is linked to a credit card. This can lead to overwhelming credit card debt and a lower credit score.
FAQs
Can you have an overdraft fee if you have no money?
If you don’t have any money in your checking account balance, then you will incur an overdraft fee if you attempt to make a purchase. To avoid this, you can use bank overdraft protection to complete the transaction.
Does overdraft protection hurt your credit?
Overdraft protection won’t impact your credit or credit score if you have your checking account linked to a savings account. That’s because money is being withdrawn from your checking or savings account and not a credit card.
However, if you have your overdraft protection linked to your credit card or a line of credit, it may impact your credit score if you don’t pay your bill on time. Even though you can’t technically overdraft your credit card, you can exceed your limit. If you utilize a line of credit, you must qualify for it which usually requires a credit inquiry. Credit checks can temporarily impact your credit score.
Is there a limit on overdraft fees?
Unfortunately, there is no limit on the number of overdraft fees your institution can charge. That’s why it’s important to shop around for a financial institution and make sure to read the fine print for fees and other charges.
Is overdraft protection mandatory?
Overdraft protection is not mandatory. Instead, you have to choose whether you want the service. If you decide to participate, then any transfers will be automatic (provided your linked account or credit line has sufficient funds).
Key Takeaways
- Overdraft protection is a service offered by financial institutions that allows customers to connect a savings account, credit card, or line of credit to their checking account.
- If your checking account is overdrawn, then the debit card transaction is completed using the connected account.
- Overdraft fees are around $35 on average and can quickly add up. There are usually fees associated with overdraft protection as well, but those fees tend to be smaller.
- Whether this service is a good fit for you depends on your spending habits and how often you overdraw your checking account.
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Taylor Milam-Samuel is a personal finance writer and credentialed educator who is passionate about helping people take control of their finances and create a life they love. When she's not researching financial terms and conditions, she can be found in the classroom teaching.
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