Swiping your debit card at the grocery store only to have it declined for insufficient funds or writing a rent check that bounces can be not only embarrassing but also costly because of the associated penalties and fees.
Overdraft protection, which the best banks for overdrafts offer, is one way to avoid that embarrassment and reduce the costs incurred in such circumstances.
What is overdraft protection?
Overdraft protection covers you when you make a transaction in an amount that exceeds the balance in your account.
With overdraft protection, debit card and ATM transactions will be approved, and checks will still clear even if you've overstretched your budget and don't have enough money to cover them.
There are often fees involved with overdraft protection, which will vary depending on your bank and the type of service you're using. The best banks for avoiding overdrafts have free overdraft protection, though.
How overdraft protection works
If you opt into your bank's basic overdraft protection service, it will cover your shortfall when you make a purchase despite having insufficient funds in your account, and then charge you a fee. You may need to pay the fee and the amount the bank put up to cover your transaction to get your account back in the positive.
The fees are fixed, usually about $35 per transaction, rather than a percentage of the transaction amount. Overdraft fees can sometimes be waived if the negative balance is below a certain amount, such as $50.
There are other forms of overdraft protection your bank may offer that can help you avoid racking up fees.
Most banks allow customers to link their checking accounts to another bank account, such as a savings account. When an overdraft occurs due to insufficient funds, the bank moves money from the savings account to the checking account, rather than covering it themselves. Banks typically charge transfer fees for this service that are usually lower than standard overdraft fees.
Another option is linking a credit card to your checking account. If you perform a transaction that exceeds your account balance, your credit card will be charged. Your bank may also charge a fee for this service.
Lastly, some banks and credit unions also offer an overdraft line of credit. When you open a line of credit, your bank transfers funds to your checking account whenever you overdraw it. The amount used to cover the overdraft accrues interest until paid off in full.
It's important to review your bank's terms and conditions before opting in for overdraft protection. Understanding how overdraft protection works at your particular institution can help you make informed decisions about managing your account.
Additionally, monitoring your account balance regularly, setting up low-balance alerts, and budgeting carefully can help you avoid overdraft fees altogether.
Example of overdraft protection
Let's say John writes a $1,400 rent check on a checking account with a balance of $900. Since John enrolled in overdraft protection by linking his savings account to a checking account, the check will clear even though his checking account is short on funds. However, the bank will charge him an overdraft protection transfer fee of $10 for the service.
Conversely, if John did not have overdraft protection, the check would bounce due to insufficient funds. The bank may also charge him a non-sufficient funds fee or even cancel his checking account in such a situation. His landlord may also charge a late fee for rent.
Benefits of overdraft protection
"Overdraft protection can save you from the fees and hits to your credit rating associated with failure to make payments in a timely fashion," says Ann Martin, director of operations at CreditDonkey.
Additionally, enrolling in overdraft protection can help cover emergency costs in times of crisis. Even if you don't have enough cash in your checking account, transactions will still go through.
If your bank offers it, linking your savings account to cover an overdraft is often a better choice than allowing the bank to cover it. Having your accounts connected is also an effective tool for overall money management.
"It reduces your potential risk for fees (as many banks still charge for overdrafts) and allows peace of mind while managing your money," White says.
Costs of overdraft protection
By setting up bank overdraft protection, you are authorizing the bank to cover a purchase that you can't afford. The cost of overdraft protection services is usually around $35 per transaction if your negative balance is above a certain limit, plus you will have to reimburse the bank.
If you decide to link a savings account instead, you may still pay an overdraft protection transfer fee. And in some cases, the bank may transfer more than you need to cover your overdrawn account.
Not all financial institutions charge overdraft fees, though. With the rise of online banks— also known as neobanks or challenger banks — it's likely you'll be able to find a financial institution that offers overdraft protection for either a low fee or none at all.
"There was a time when almost every bank charged overdraft fees, but there is currently a movement to eliminate or reduce overdraft fees across banking," says Jennifer White, a senior director in the global banking and payments intelligence practice at J.D. Power.
How to set up overdraft protection
Check out your bank's website or call the customer service line for instructions on setting up overdraft protection.
You will typically need to sign an agreement opting in to overdraft protection. Read it carefully and be sure you understand the fees and structure of your bank's overdraft protection program. Also know that you can opt out at any time.
Overdraft protection FAQs
What exactly is overdraft protection?
Overdraft protection reduces the chance that a transaction will be declined because you have insufficient funds in your checking account.
How does overdraft protection work?
Overdraft protection works by authorizing your bank to cover the difference when you don't have enough money or linking another of your bank accounts to pull money from or borrow from the bank through a line of credit. It's important to review your bank's terms and conditions to understand how overdraft protection works at your particular institution.
Are there fees associated with overdraft protection?
If you opt into overdraft protection, you may be charged a fee when your account is withdrawn, and the bank pays the difference; if the bank has to initiate a transfer from another bank account to cover the purchase; or if your account remains overdrawn for a certain number of days. If you authorize overdraft protection in the form of a line of credit, you will be subject to interest charges.
How can I set up overdraft protection?
Visit your bank's website or call customer service to set up overdraft protection. Carefully review the overdraft protection agreement and make sure you understand common bank fees before opting in. If you opted out of overdraft protection when opening your account, call your bank in order to sign up.
Is overdraft protection necessary?
Overdraft protection isn't necessary for those who keep a buffer in their checking accounts. However, it can help prevent important transactions from being declined. Pending transactions may not always reflect in your available balance immediately, making it hard to track your exact funds. For example, if your rent is due but recent purchases haven't cleared, you could overdraw your account without realizing it. Overdraft protection can cover the shortfall, though fees may apply.
