What Is Overdraft Protection, and How Does It Work?

  • By Greg Brown
  • Published: Jun 12, 2023
  • Last Updated: Jun 20, 2023

What Is Overdraft Protection

Every industry has inflection points; some are massive, and others are small but very significant. In 1728, the Royal Bank Of Scotland gave a merchant, William Hog, the world’s first overdraft. Mr. Hog badly needed the concession to remain in business.

What is Overdraft Protection?

Overdraft protection ensures checks or money transactions are covered if insufficient funds are in the withdrawing account. Your bank automatically moves funds from another account to cover the overdraft. Of course, this fantastic service has a fee attached and sometimes more than one. The sales pitch; the overdraft charge is far less than the NSF fee

Overdraft protection became common practice in the 90s and grew into a significant money maker for banks and credit unions. Overdraft began as a modest add-on service and morphed into a $30 to $35 billion “pure profit center,” with some banks earning over one billion yearly. Overdraft services became so profitable that a former bank CEO named his yacht “Overdraft.”

How Overdraft Protection Works?

According to Bankrate.com, the average charge for a single overdraft is $33.83. This charge does not include any fees from the merchant for a bounced check. Try a bank line of credit, if available, rather than using an internal savings account for checking shortfalls. HECMs are popular for homeowners and offer advantages such as extra cash when needed. Also, try linking your checking account to a credit or debit card for temporary cash needs.

Start using a debit card for all purchases and cut out paper checks altogether. If the cash is not in the account, a short-term embarrassment will be yours to endure; however, there will be no extra fees to drain your account. You will also learn rather quickly “How to Manage Your Money.” 

In recent years, banks have been reducing overdraft fees while some have cut the fee out altogether. Bankrate’s 2022 Checking Account survey states the fee has dropped eleven percent to $29.80. Bank Junk Fees are skyrocketing in other areas, such as an out-of-network ATM transaction has risen to $4.66. The average ATM surcharge across the nation is $3.14 per transaction. 

Banks are great at double-speak, meaning they tout interest-bearing checking accounts as a way for consumers to put their money to work. However, unlike savings accounts, interest-bearing checking reports record-low yields.

Types and Costs of Overdraft Protection

There are several options to arrange overdraft protection. One or more types may be available depending on the financial institution or bank you choose. Here are two main types of overdraft protection:

Personal Overdraft Protection

Most overdrafts come with fees attached, which is the only way the above CEO afforded his boat. Before agreeing to use overdraft protection, personal account holders must understand all the associated fees. Overdrafts usually have an establishment fee for setting up the account. Next, a monthly administration fee will be needed to handle the immediate transactions. And, of course, the fee for going over your current balance. 

Each bank has its own set of fees and terms. Some institutions have no establishment fee but charge an exorbitant administration fee. Banks are always looking out for the little guy. 

Business Overdraft Protection

Small and large businesses use overdraft protection for a variety of unexpected expenses. Overdrafts ease pressure on daily working capital requirements and unexpected expenditures. Larger businesses use overdrafts as a form of finance to ease constant money fluctuations. Larger overdraft protection transactions often need company collateral, depending on the level of risk. 

What Factors Should You Consider When Choosing Overdraft Protection?

  • Arrangement fees are usually a percentage of bank charges to set up a business account. This fee covers administrative costs and a thorough investigation into the business profile and level of risk.
  • Business maintenance fees are generally taken directly from the account and consist of an annual or monthly charge to maintain the credit report.
  • Overdraft interest is charged to the account for any overdrawn balance. The interest is calculated from the end-of-day overdrawn balance and charged to the account at the statement date.
  • Businesses generally have a cap on the amount they can use for overdrafts. Any firm exceeding this cap may be charged additional monies and utilization fees.
  • In some circumstances, costs are incurred for larger organizations due to the overdraft size. Additional securities and guarantees may be needed to cover sizable transactions. 

Savvy business owners and executives know how to use overdraft protections to their advantage. Some see overdrafts as a quick and efficient means for short term-borrowing with caps tailored to a business’s needs. When the amount needed is difficult to know, interest is paid only on the amount drawn. Due to the short-term nature of overdrafts, the amounts are generally not included in debt calculations related to the business.

Pros and Cons of Overdraft Protection

How Does Overdraft Protection Work

Overdraft protection is excellent for individuals short on money or temporarily living paycheck to paycheck. Businesses find overdrafting useful if the business is operating on limited cash flow, among other situations. 

However, without thoroughly considering the entire process of monitoring your credit accounts, situations that will do more harm than good may arise. In the early 2010s, banks and credit unions had free rein to charge whatever fee they deemed appropriate. Despite federal rules going into effect regulating overdraft fees, banks were still pulling in billions of dollars with fees on top of fees. For example, an overdraft occurs, and your bank charges a fee; on top of the overdraft fee, there would be a transfer fee. 

Rules, which went into effect on January 19, 2010, gave a brief description of the types of transactions in which a fee may be imposed. At the time, banks were charging customers huge fees for trying to access their money with an ATM card. On July 10 of that same year, the Federal Deposit Insurance Corporation (FDIC) implemented opt-in requirements for ATM overdrafts.

For individuals and businesses alike, the single biggest problem is the interest the banks charge on overdraft amounts. Interest is charged on the amount used and is always much higher than other short-term bank loans. 

To Wrap Up

Overdraft protection can be a godsend on certain occasions, but they are few and far between. Make sure to read between the lines of any opt-in agreement; without a doubt, it is heavily slanted toward the bank’s best interest, not yours. Think long and hard if you truly need this service.

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