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I recently received the question from a reader asking me what is overdraft protection, and whether or not it makes sense for him to get it. I am going to answer his question today and show both the advantages and disadvantages to overdraft protection.
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What Is Overdraft Protection
Before I talk in depth about overdraft protection, I want to make sure everyone is on the same page with understanding what is overdraft protection. Overdraft protection applies mainly to bank accounts, at least it will for purposes of this post.
When you have a checking account, you have withdrawals and deposits out of and into that account. Should you ever withdraw more money than you have in your account, your purchase or check will be declined, unless you have overdraft protection. With overdraft protection, the bank will allow you to take more money out of your checking account than you have in so that the purchase goes through. All you have to do is make a deposit into the account so that your negative balance becomes positive again.
History of Overdraft Protection
Back before 2010, overdraft protection was simply given to bank account holders without question. If you had a bank account, you had overdraft protection. Every time you exceeded your balance, the bank would charge you typically $35 per incident.
The crazy thing was, many times you didn’t know you overdrew your account until you logged into your account or you received a letter from the bank a few days later. Because of this, many people incurred a handful of overdraft fees.
For example, let’s say you forgot about a check you wrote and overdrew your account. That’s $35. But, since you forgot about the check, you think you have plenty of money in your account. So, you buy your groceries (another $35 overdraft fee), your gas (another $35 overdraft fee), and rent a movie at RedBox (another $35 overdraft fee). All told, you just paid $140 in overdraft fees.
And these overdraft fees add up. A 2007 study by the Center for Responsible Lending said consumers paid $17.5 billion in overdraft fees annually. That is some serious money.
How Overdraft Fees Work Now
This all changed in 2010 when new laws went into place. Overdraft protection still exists, but instead of you being automatically enrolled in overdraft protection, you now have to opt-in instead. Also, the fee for overdraft protection still exists, but in many cases, it is much lower than $35. Typically it is around $15-$20.
Why Opt-In? The Advantages
So why would you opt-in to have overdraft protection? There are a few reasons:
- Some consumers use the overdraft protection as a “float” between paychecks. These people are spending more than they have and need the overdraft protection to pay for things until they get paid again.
- Others use overdraft protection as emergency cash. In the event an emergency arises, they overdraft their account and pay the fee. While it is smarter to simply have the cash you might need sitting in an emergency fund, using overdraft protection this way may be smarter than using a credit card because with a credit card, you may be tempted to not pay the balance in full and pay more interest in the long run.
- Still, others opt-in for overdraft protection to avoid embarrassment. They don’t want to be at a grocery store or gas station only to have their debit card decline because they have no money. This can be a very traumatic event for people.
Why Not Opt-In? The Disadvantages
Of course, there are reasons why you shouldn’t opt-in for overdraft protection:
- There is still a cost associated with overdraft protection. It might not be as much as $35 per incident as before, but it still costs you money when you use it.
- As I touched on above, it could be cheaper to use your credit card instead. If you pay off the balance in full, you can essentially get a few weeks worth of an interest free loan before you need to pay the bill.
- You could also sign up for email alerts from your bank to keep in the know when a check that you might have forgotten about gets cashed or when your balance drops below a certain point.
Shop Around For What Fits You Best
With the new law, many banks have completely changed the way they handle overdraft protection. As a result, it is wise to shop around for the bank that offers you the best overdraft protection to fit your needs.
For example, some banks allow you to link your savings account to your checking account. Should you overdraft your checking account, the bank will draw the money needed from your savings account. I’ve found that of the banks that offer this, some still charge a fee for this while others do not. SO even if your bank offers this, make sure you confirm they still will not charge you for overdrafting your account.
Additionally, some banks offer lines of credit instead. I bank with Capital One 360 which does just this. I applied and received a $1,000 line of credit on my account. Should I ever exceed my checking account balance, the bank will loan me the money. I then pay interest on the overdrawn amount for every day I have a negative balance. I overdrew once and at the end of the month, they debited my account for the interest I owed them. In that time, I paid $0.39 interest.
5 Tips To Avoid Going Into Overdraft Protection
If you do decide to opt for overdraft protection, what are some ways you can ensure that you avoid making a regular occurrence that you use it? Here are 5 ideas for you.
Live Within Your Means: Not living within one’s means is the main reason most people get into debt. So, when it comes to avoiding overdraft, nothing can beat this age old advice. It’s not hard to live within your means if you have a sound budget. So, create a budget based on your monthly income and try not to exceed its limits. Make sure that you set aside some money in your budget for savings and emergencies so that you will have the money readily available in case an emergency occurs.
Follow Your Budget On The Go: While having and using a budget is great, you have to know if you are OK to spend while on the go. For this reason, make sure your budget is available on the go. Many programs, like You Need A Budget have a mobile app so that you can check out how much you have to spend any time you want. And if you are old-school and use an excel spreadsheet to budget, be sure to put it in Dropbox and add that app to your smartphone so you can check on while out and about.
Ask Yourself If You Really Need Overdraft: Before applying for an overdraft or withdrawing the overdraft money from your ATM, stop and ask yourself whether or not you really need the money. Many times, we can solve our financial problems without borrowing money. For example, you can ask your creditor for a time extension, ask your employer for an advance or borrow the equipment (such as a laptop) you need from a friend rather than buying it.
Explore Cheaper Sources Of Funding: You can never rule out emergencies however careful you may be. But before resorting to overdraft, explore other sources of funding that are cheaper in terms of fees and interest rate. For example, you can ask a relative or a friend if they can give you a short term loan. If it’s your lucky day, they may even offer an interest-free loan for an indefinite period. Think of how other people without overdraft protection manage and you will find a way out.
Do Not Open An Overdraft Account: The most guaranteed way to avoid going into overdraft protection is not to have overdraft at all. When you do not have overdraft, there is no way you can overdraw your account. So avoid opening an overdraft account. If you already have one, consider closing it. This may inconvenience you for a while if you are use to overdrawing your account. But you will be forced to find other cheaper sources of funding in case of an emergency.
It’s important to understand what is overdraft protection, and how it can help and hurt you. Remember, it’s your money. The only person that cares about it is you. So assess whether or not you need overdraft protection and then find a bank that offers the cheapest overdraft protection that meets your needs.