Overdraft Explained: Fees, Protection, and Types

What Is an Overdraft?

An overdraft occurs when there isn't enough money in an account to cover a transaction or withdrawal, but the bank allows the transaction anyway. Essentially, it's an extension of credit from the financial 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, an 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, an overdraft fee can run upwards of $35.

Understanding Overdrafts

With an overdraft account, a bank is covering payments a customer has made that would otherwise be rejected, or in the case of actual physical 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.

While banks can charge overdraft fees, they cannot change the order of a customer's transactions in order to collect more overdraft fees. In 2010, Wells Fargo was fined $203 million for the predatory practice of structuring customer withdrawals in a way that maximized overdraft fees.

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 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.

Overdraft Protection

Some but not all banks will pay overdrafts automatically, as a courtesy to the customer (while charging fees, of course.) Overdraft protection provides the customer with a further tool to prevent embarrassing shortfalls that reflect poorly on your ability to pay.

Usually, it works by linking your checking account to a savings account, other checking account, or a line of credit. If there's a shortfall, this source gets tapped for the funds, ensuring that you won't have a check returned or a transaction/transfer declined. It also avoids triggering a non-sufficient funds (NSF) charge. 

The dollar amount of overdraft protection varies by account and by bank. Often, the customer needs to specifically request it. There are a variety of pros and cons to using overdraft protection, but one thing to bear in mind is that banks aren't providing the service out of the goodness of their hearts. They usually charge a fee for it.

As such, customers should be sure to rely on overdraft protection sparingly and only in an emergency. If the overdraft protection is used excessively, the financial institution can remove the protection from the account.

The Bottom Line

An overdraft is a temporary loan that allows bank customers to continue paying bills or withdrawing money even after their accounts are empty. This can be useful in emergencies, especially if the bank offers overdraft protection. However, overdrawing an account incurs additional penalties or interest, and should be avoided if possible.