Overdraft Protection: Pros and Cons

Checks and other debit transactions clear when you sign up for overdraft protection, even if your account lacks sufficient funds.

In exchange for this service, however, your bank may charge hefty overdraft fees. Is overdraft protection worth having? Here is a look at the pros and cons.

How Overdraft Protection Works

Consumer banks used to automatically add overdraft protection to all checking accounts, but now you must opt in to or formally accept this feature.

Overdraft protection is used when there are insufficient funds in your account. It can also be used when have enough money in your account, but funds are on hold and not yet available for spending.

When the bank approves a debit purchase greater than your account balance, your account is overdrawn. There are often two outcomes. First, the bank automatically transfers funds between your accounts if sufficient funds exist in an associated account.

Second, the bank may choose to pay for the transaction on your behalf, creating an obligation between you and the bank. In both situations, as the bank has to perform additional processing for the transaction, it may choose to charge an overdraft fee.

Overdraft Fee vs. Non-Sufficient Funds Fee

An overdraft fee (or overdraft protection) only applies to one-time debit and ATM transactions. If the bank decides to allow the transaction that will cause your account balance to be negative, it assesses an overdraft fee.

If the bank rejects the transaction and chooses not to pay for it on your behalf, there are several different possible outcomes. First, your debit or credit card may be declined. You won't be charged a fee, but your transaction won't process. Second, non-electronic charges like checks may incur a non-sufficient funds (NSF) fee. The check won't be processed, but you will incur a penalty that is similar to an overdraft fee.

The party receiving the bad check can demand reimbursement for the returned check fee and report you to ChexSystems—a consumer credit reporting agency that tracks activity related to closed checking, savings, and other deposit accounts at banks and credit unions. This repository is similar to a credit report for your banking history and may result in unfavorable lending terms or refusal of service in the future.

Pros of Overdraft Protection, Explained

When you sign up for overdraft protection, your bank will use a linked backup source that you designate—a savings account, credit card, or line of credit—to pay for transactions whenever the checking account lacks the needed funds. Here are several benefits of overdraft protection:

• Your transaction will likely go through. Whether it's an emergency payment or simple mistake, the ATM will give you cash, the debit card transaction will process, or the check will clear.
• The recipient isn't notified of the close call. This is especially important in situations where your financial situation is of concern to the receiving party. An example is a business partner not being notified of your personal bank account funds being low or a landlord not knowing a tenant's financial situation.
• You often avoid overdraft fees and other penalties. If you're unaware of your bank balance and lack overdraft protection, you may be charged multiple overdraft charges in a single day.
• The annual cost may be less than a single overdraft fee. Overdraft coverage is a periodic charge auto-debited from your account. This service often costs less than paying an overdraft fee.
• Emergency transactions often still go through. Even if your bank account is insufficient to cover a transaction, you usually are covered in the case of an emergency.

Cons of Overdraft Protection, Explained

There are several drawbacks to overdraft protection. The service usually isn't not free, and there are implications if it's abused.

• This service often comes with a charge. Like insurance, the coverage is there if you need it. However, if you manage your bank account balance and never overdraw, you're paying for this service just to never use it.
• You may still have to pay fees. Some banks limit the coverage or assess a fee if multiple overdraft transactions have occurred. Ensure you understand your bank's coverage before agreeing to the protection.
• Your transaction still may fail. If you don't have enough funds in other linked accounts, your transaction may fail to be processed anyway.
• It's often easier to overspend. Just because you have overdraft protection doesn't mean overdrafts are an advisable practice. You still need to manage your bank account, budget your spending, and know your limits.
• Your banking relationship may suffer. If the overdraft protection service is abused, a bank may revoke membership in it, especially if your bank account remains negative for too long.

What Happens When You Don't Have Overdraft Protection

Every bank will assess its own overdraft fee and charge different rates for overdraft protection. If you are making a small purchase, it's often advised not to write a check or use your debit card if you’re unsure whether your funds will cover the purchase. It is common for a transaction smaller than the overdraft fee to result in a penalty larger than the failed transaction itself.

Terms and conditions for overdraft fees vary significantly from one bank to another. If your bank’s overdraft fees are high, you may find it less expensive to pay using a credit card. This is different from linking your overdraft protection directly to a credit card, which can be pricey because the credit card treats the linked transaction as a cash advance with a high interest rate and no grace period.

Other Ways to Avoid Overdraft Fees

While it may be worth opting in if you don’t want transactions to be declined, a better choice is to sign up for email or text alerts to flag low checking account balances. You can often create alerts for specific bank balances or receive bank statements periodically. These alerts will give you an opportunity to add funds to your checking account, wait to make a purchase, or use an alternate form of payment.

You can also avoid overdraft charges with some banks’ free overdraft transfer services, which will automatically transfer money in preset increments (such as $100) into your checking account from a linked savings account when the balance is low.

The Bottom Line

You may want peace of mind from having overdraft protection, or you may feel it's not necessary. If you're on top of your finances or aren't worried about overdrawing your account, overdraft protection may not be for you. However, if you want that service from the bank and need to know your transactions will go through, even in the case of an emergency, ask your bank about their overdraft protection service.