Overdraft Protection: Definition & How to Avoid It

Overdraft Protection: Definition & How to Avoid It
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If you spend more money than the available funds you have in your account at the time, one of two things will happen. Either your transaction will be declined, or your bank will cover it for you. However, if your bank covers your transaction, you’ll very likely be charged a fee for the courtesy of not declining your transaction when you had insufficient funds in your account.

Overdraft fees can add up quickly as more and more items attempt to post to your account. One way to avoid these fees is by signing up for overdraft protection.

Types of Overdraft Fees

It’s important to note that there are several types of fees you can find yourself paying when you overdraw your account. And, sometimes people can confuse these fees and use them interchangeably, although they’re different. However, understanding the different types of overdraft fees you may have to pay will keep you mindful of ways you can avoid them.

  • Non-Sufficient Funds (NSF) Fees happen when your bank declines or rejects an item that will bring your balance into the negative. When an item is rejected, either it will be paid or it will incur an NSF fee. However, a single transaction cannot incur both NSF and overdraft fees. Even though the transaction is returned unpaid, you will still have to pay the NSF fee, which varies depending on your bank, but averages around $35 per returned item.
  • Overdraft Fees are similar to NSF fees, in that they average approximately $35 per transaction, but these are incurred when the bank chooses to process the payment even though you do not have enough money in your account to cover it. Banks can choose to process or decline a transaction, but if it pays the transaction for you, then you owe any shortfall you had plus the bank’s overdraft fee. Keep in mind that banks can charge overdraft or NSF fees for each item that processes while your account balance is negative. 
  • Extended Overdraft Fees are only charged when your account has been overdrawn for an extended amount of time. This means that when you've received either an NSF or overdraft fee, and have not brought your account out of the red, then you’re likely to be charged yet another fee. Each bank has its own policy regarding how often it can charge this fee. For example, Bank of America’s overdraft and NSF fees are both $35, however, you're also charged $35 every five days until you have a positive balance. If you don’t take care of your overdrawn account in a timely manner, you run the risk of your bank closing it. 
  • Overdraft Protection Fees occur when you don’t have enough money to cover a particular transaction that posts to your account, but you've opted-in to use your own money, or a line of credit, to cover it. 

What Is Overdraft Protection?

Overdraft protection is a service offered by many banks that prevents your account from spiraling out of control when you spend more than you have. With overdraft protection, when you have insufficient funds in your account, the bank covers the transaction for you, but this courtesy comes at a cost.

Without overdraft protection, the transaction will not be covered and you'll likely be charged an NSF fee. Considering that most overdraft fees can range between $30 and $35 on average, it's important to make sure you have a safety net in place.

Overdraft protection typically isn't an automatic process, and you must opt-in for this sort of coverage. In order to protect your account from overdraft or NSF fees, you must first link your checking account to either a credit card, your savings account or another type of approved funding source. If transactions such as debit card purchases, wire transfers or paper checks you’ve written post to your account and you don’t have enough to cover them, then your overdraft protection kicks in to cover any shortfalls.

Although having overdraft protection is not a way to avoid fees entirely – you will still incur transfer fees of $10 to $15 on average – they’re less costly than a returned item or overdraft fee. Also, the merchant you’re paying may charge you fees for the declined payment, or your bank may charge you extended overdraft fees until you bring your account back out of the red.

Overdraft Protection Example

It’s easy to get lost in the never-ending maze of overdraft fees. And it’s equally easy to be confused as to when overdraft protection is triggered, or how much you’ll end up owing at the end of the day.

For example, let's say you've linked your checking account to a secondary funding source such as a savings account. Then you have a $100 transaction come into your checking account that only has $50 in it, and your bank covers you for the $50 you’re short. You will now owe your $50 shortfall as well as whatever your bank charges you for the overdraft protection courtesy. If your bank charges you $15 per overdraft protection transfer it makes on your behalf, then you need to deposit at least $65 into your account to bring it back up to a positive balance.

Overdraft Protection Pros

The most obvious pro of having overdraft protection is that your transaction goes through as you intended and the merchant or person is paid. However, it’s worth noting that although the money covering the shortfall is yours, you still have to pay the transfer fee to have the money moved from one account to the other. You aren’t completely out of the woods with overdraft protection, but it can help you avoid merchant fees and potentially embarrassing or costly declines in addition to costly bank fees.

Cons of Overdraft Protection

Overdraft protection can help you out in a pinch, but you shouldn’t become reliant upon it. Even though it’s less costly than having your transaction declined entirely, you don’t want to get too used to using on it. These fees add up, and a few overdraft protection fees per month can easily result in hundreds of dollars annually.

Also, if you use a line of credit to cover your overdraft protection – such as a credit card – then you'll have to pay interest on these transferred funds, because the transfers are treated as cash advances, and do not have a grace period before interest begins to accrue.

Better Money Management

The best way to avoid using more money than you have in your account, and triggering your overdraft protection, is to stay on top of your finances. Automated payments for things like gym membership and cell phone or cable bills can sneak up on you.

One way to steer clear of overdrawing your account is to pay your bills manually rather than setting up automated payments. If you forget about an upcoming automated payment, your balance can get thrown off, causing you to spend more than you actually have in your account. Fortunately, most banks give consumers the option of accessing and monitoring their account balance at any time using online or mobile banking.

Through online or mobile banking or by calling your bank’s customer service number, you can set up low-balance alerts which notify you that your balance is getting low. Using low-balance email or text notifications helps you to avoid overdrawing your account by alerting you to deposit more money or to watch your spending.

You can also opt to have your bank transfer money from one account to another when your balance is low. Setting a predetermined amount that is automatically transferred when your account gets low is another tool some banks offer to help you stay in the clear. This way, you can skip the fees associated with having the bank transfer money when an item posts that would have otherwise overdrawn your account.

Other Banking Options

Many traditional banks with brick-and-mortar locations charge overdraft fees, and it all adds up. In fact, 2019 saw large banks bringing in nearly $35 million in overdraft-related fees alone. Overdrawing a bank account is avoidable, but it does happen to even the most vigilant account holders. However, consumers are becoming more savvy when it comes to weighing their banking options, and are choosing to put their money with banks that offer more.

While most traditional banks charge various types of overdraft fees, there are some banks that offer no-cost or low-cost accounts. These are generally online-only banks, meaning there is no physical location or branch you can visit to bank with a teller, and making deposits to online-only banks can be a bit more involved. But, if you’re the sort who prefers to do your banking online, via mobile apps or over the phone, then an online-only bank may be the option for you.

Because online-only banks have lower overhead than their brick-and-mortar counterparts, they're able to pass some savings onto customers, like competitive interest rates or zero-fee accounts. A zero-fee account will typically have no account maintenance fees, minimum balance requirements or overdraft fees.

With most zero-fee bank accounts, you cannot overdraw your account or incur fees, because transactions that would send you into a negative balance are generally declined, depending on the bank or the type of overdraft coverage you choose.

Accounts With Zero Overdraft Fees  

Before you decide to put your money into a bank, be sure you’re aware of its policies regarding overdraft and other account fees. By familiarizing yourself with your user agreements and schedule of fees, you can avoid any unpleasant surprises when you find yourself with an overdrawn account.

One online bank, Simple, has free online checking accounts for customers who prefer to bank with a smartphone via mobile apps. You won't incur overdraft fees and can even earn a competitive 1.00% APY on Simple’s Protected Goals Account. There are no monthly maintenance charges, and your account cannot become overdrawn.

Another bank account that touts itself as a no-fee account is the Capital One 360 Checking Account. Capital One is a major United States bank that offers a fee-free online account, but you cannot use the branch locations.

You can opt to have transactions declined that will cause your account to become overdrawn, you can set up free automatic transfers from your savings (overdraft protection) or you can take advantage of a full business day grace period to deposit money to rectify your negative balance before you are charged a $35 fee. If you bounce a check, however, you incur a $9 NSF fee, regardless of the type of overdraft coverage you choose.