When Good People Write Bad Checks

If you've ever overdrawn your checking account, you know how painful those overdraft fees can be. How can you avoid paying exorbitant fees when you overspend? Banks offer a few types of overdraft protection that can keep you fee-free but don't think they're all created equal. Here's what you need to know to make sure that your overdraft plan isn't overblown.

Protect Yourself

Overdrafts happen. You don’t have to be an idler to write a check or buy something with a debit card only to find that you're using the wrong account, your recent deposit hasn't gone through yet, or you simply misjudged the amount of money in your checking account.

The best way to avoid overdraft fees is simple: Avoid overdrawing your account. These days, online banking has made avoiding overdrafts easier than ever. You can get an email or phone alert whenever you cross a low-balance threshold. You can then transfer funds before a pending transaction puts you below the $0 mark. If you're not tech-savvy, an old check register helps to keep tabs on spending. 

If you do overdraw your account, there are steps to keep things from spiraling out of control.

What Is Overdraft Protection?

Overdraft protection is a service your bank provides that pays for things after your account goes below $0. Any checks you write against your account won't bounce and your debit transactions will still go through. Overdraft protection began as a discretion banks extended as a courtesy to preferred customers when they didn't have enough funds to cover their transactions. This service eventually evolved into a lucrative financial service offered to just about anyone.

Types of Overdraft Protection

The most common form of overdraft protection is based on your credit score. The bank runs a credit check to determine a suitable credit limit. Like a credit card, the credit line is revolving. You can use any amount up to the limit. In essence, the facility is a short-term loan. If you dip below $0 you won't need to worry about your mortgage payment bouncing because you wrote a big check to cover an unexpected dishwasher repair.

Like any credit product, overdraft protection is at the discretion of the bank. This means the bank can approve and cancel the service at any time. If you fail to repay the balance and continuously maintain a negative account, the bank may decide to close the credit line and collect the balance. In most cases, interest continues to accrue.

While overdraft protection can provide some peace of mind in an emergency, it's important to remember that it is a fee-based service. Most banks charge you a regular monthly fee and because it's considered a short-term loan, they usually charge interest. Keep in mind, you are responsible for any negative balance, which means you have to bring the account current.

Linked Savings Accounts

There is a way to avoid overdraft fees and still give yourself worry-free banking. Talk to your bank about linking your checking and savings accounts together. When you overspend with your checking account, the bank will cover the shortfall from your linked savings account. This is often the best type of overdraft protection because you avoid paying high overdraft fees and interest.

Your savings account needs a decent balance for this to work. And although there aren't any overdraft fees involved, you may incur a transfer or withdrawal fee every time it kicks in. These charges are fairly typical for savings accounts. It's a good idea to check with your financial institution about its transfer procedures and fees.

Overdraft Line of Credit

A similar kind of protection is the overdraft line of credit. Instead of having a savings account linked to your checking account, the bank links a line of credit or a credit card. The obvious downside to using an overdraft line of credit is the fact that you’re using credit to fuel your purchases. If the linked credit is a credit card, you can also count on paying the cash advance rate for the money you use. These facilities are not as popular though.

Credit Score Implications

Overdraft protection can affect your credit score. If you have bounce protection and don’t bring your account back to good standing soon enough, you can bet your credit score will take a hit. If you use an overdraft line of credit or linked credit card, keep in mind the potential negative consequences of having that extra money on your card, especially if you have a tough time repaying the balance.

Criticism of Overdraft Protection

Overdraft protection is a very controversial financial product. That's because banks are often able to skirt usury laws with overdraft fees, even though many people feel that overdraft protection is a loan. Loans are governed by the Truth in Lending Act (TILA) of 1968. But because overdraft protection is considered a fee-based service rather than a loan, it's not covered. This means you could be paying a hefty premium for the right to overdraw your account. You’ll see that some kinds of overdraft protection services can be a lot like payday loans. So while you may be able to rely on it from time to time, it should be used as an insurance policy in emergency cases only and not for everyday use.

The Bottom Line

If you are hit with overdraft fees for linked-account or bounce protection, the easiest way to avoid having to pay is to call your bank and ask. If you’ve been a customer in good standing for a while and this is your first or second time overdrawing, it’s likely your bank will let you off the hook.

Of course, the best choice is to not overdraw your account at all, but this is obviously not the easiest answer for many people. Overdraft protection is a huge moneymaker for banks these days, and they know it. If you are going to overdraw your account, it pays to have decided in advance which kind of overdraft protection is the most beneficial for you.