Banking •
February 28, 2023
How do overdrafts work?
An overdraft happens when you spend more money than you have in your checking account. Here’s everything you need to know about bank overdrafts.
Do you know how much is in your checking account right this minute? If you’re like most of us, the answer is probably no, not exactly—and that’s okay!
But what happens if you make a debit card purchase for more than your current checking account balance? It leads to what’s called an “overdraft.”
So what exactly is an overdraft, and how does it affect your finances?
What’s an overdraft?
An overdraft happens when you spend more money than you currently have in your checking account, but the bank processes the transaction anyway. For instance, if you have a $200 balance and try to purchase $225 worth of groceries using your debit card, that transaction could result in an overdraft.
Purchases, transfers, ATM withdrawals, written checks, or automatic bill payments can cause overdrafts.
When a transaction is started that exceeds your current bank balance, the bank may still let the transaction go through. To do this, they essentially loan you a small amount of money automatically—which you’ll later have to pay back. They’ll also charge an overdraft fee (more on this later).
Depending on how your account is set up, overdrafts may or may not happen. For example, suppose you’ve not opted into overdraft protection (an optional service offered by banks and credit unions). In that case, any transactions exceeding your available balance will simply be declined.
To illustrate this, consider this example: You have a current bank account balance of $195. You go to the grocery store and try to buy $250 worth of groceries. Here’s what would happen with and without overdraft protection:
With overdraft protection: If you’ve opted into overdraft protection, your bank will approve the transaction and charge you an overdraft fee. This will result in a negative balance of -$55, plus whatever fee the bank charges. You’ll need to deposit more money to keep your account balance up.
Without overdraft protection: Your bank will decline the transaction if you do not opt into overdraft protection. The payment won’t go through, and you’ll have to use a different payment method or put some items you’d like to buy back to lower the transaction amount. Your bank account balance won’t change, and there won’t be any fees.
In either case, you should get a notification from your bank about what happened and any next steps you need to take. This can come from a text message, automated call, or email.
How do overdrafts work?
When an overdraft occurs, what’s technically happening behind the scenes is that your bank is lending you a small amount of money. This allows the transaction to actually go through.
When a transaction is requested for more than the available balance, the transaction is declined by default. This can result in an embarrassing situation in the checkout line—or worse, a bounced check to your landlord.
For this reason, banks offer overdraft protection. With protection enabled, the transaction will still go through. However, the bank covers the shortfall in funds with their own money, which you pay back later.
Overdrafts can also result in a negative bank account balance. As a result, your bank will require you to deposit more money to bring your account back into the positive. If you don’t, you could face additional fees, and your ability to make further transactions will be limited.
Alternatively, some banks allow overdrafts to be automatically covered by other accounts you own. For instance, you can set it up so that if you overdraft your checking account, the shortfall is automatically covered by your savings account or even a credit card. These setups may charge a small transfer fee, which is often smaller than the standard overdraft fee.
Overdraft protection
Overdraft protection is an optional bank account feature that enables your account to overdraft. By default, it’s turned off—so a transaction for more than your current balance will simply be declined.
Declined transactions can be inconvenient or even embarrassing. They may also result in fees from the merchant. For instance, most merchants charge a fee for “bounced” checks—or checks that don’t go through.
By opting into overdraft protection, you authorize your bank to cover the shortfall in funds if a transaction of more than your available balance is requested.
Overdraft fees
When an overdraft occurs, your bank will likely charge you a fee. The average overdraft fee is currently around $30, although your bank may charge more or less. This fee is also sometimes called a non-sufficient funds (NSF) fee.
Overdraft fees happen per occurrence. So in some cases, you might overdraft multiple times before you even realize it, resulting in numerous overdraft charges in a single day. To avoid hefty fees, it’s wise to monitor your account balance via online banking and opt-in to notifications for overdrafts.
Also, keep inmmind that the overdraft fee will be in addition to the amount you overdraft your account. For example, if you have a $100 balance and make a $150 purchase, your bank charges a $30 overdraft fee. This will result in a balance of -$80 ($50 plus $30 overdraft fee).
How to avoid overdraft fees
Overdraft fees can add up quickly, with most banks charging between $30 and $35 per occurrence. So are there ways to avoid these fees?
There sure are! The simplest way is to opt out of overdraft protection altogether. But there are other options to consider, as well.
Opt out of overdraft protection
Overdraft protection is an optional feature. If you opt-out of it by contacting your bank, then overdrafts in your account can’t happen. Instead, any transactions that exceed your account balance will be automatically declined.
Monitor your account
Knowing your account balance will help you avoid any transactions resulting in an overdraft. Here are some things to keep in mind:
Remember that deposits can take time to “clear” and become available to spend.
Checks you write may be cashed at any time—even weeks after you wrote them. So be sure to account for any outstanding checks.
Some banks let you set low balance alerts that notify you when your balance drops below a certain threshold.
Watch out for any automatic payments you have set up, like subscriptions or automatic bill payments.
Stick to your budget
If you’re using a budget, you’ll be less likely to overspend and overdraft your account. Budgeting starts with getting a handle on all the personal budget categories, then tracking your spending using a budgeting app.
You should also balance your budget frequently by comparing your actual spending to your planned spending.
Use a credit card when needed
If you’re facing a shortfall in your budget and need to make an essential purchase, reaching for a credit card can sometimes make sense.
Unlike debit cards, you can’t overdraft a credit card. Credit cards let you spend borrowed money and pay it back over time.
Be warned, however: Credit cards charge high-interest rates, so this strategy can be costly. But if you can afford to pay off your credit card quickly, this may still be cheaper than an overdraft in your account.
In fact, if you can pay off your whole balance in full each month, you won’t pay any interest at all.
Sign up for email or text alerts
Many banks let you opt-in to automated alerts when your overdraft on your account or even when your balance falls below a certain threshold. These notifications can help you to avoid overdrafts without constantly having to manually check your balance.
Will overdrafts affect my finances or my credit score?
The fees that come with overdrafts can definitely hurt your finances. The $30 to $35 per day banks charge really adds up.
If you’re facing financial difficulties and consistently overdrawing on your account, it may be worth opting out of overdraft protection. This will prevent you from paying overdraft fees. You could then consider taking out a personal loan to help you meet your financial needs.
Do overdrafts hurt your credit? In most cases, no—overdrafts in your account won’t hurt your credit score. Checking account information is not reported to your credit profile.
An overdraft every once in a while isn’t a big deal. You simply pay the fee, deposit more money into your account, and go about your day.
However, frequent overdrafts could lead to problems with your bank—and potentially future banks you may try to do business with.
Checking account activity is reported to ChexSystems, which is like a credit report for your banking life. When you open a new bank account, the bank will look at your ChexSystems report to see if you’ve been a responsible customer. For example, if they see many overdrafts or other issues with your account, they might be less likely to approve you for a new account.
Bottom line
An overdraft occurs when you spend more money than you have in your account.
It’s best to avoid overdrafts in your account to save on fees. Better yet, find a banking solution that doesn’t have fees!
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