Writing a bad check is a simple mistake that can snowball into a nightmare of bounced checks, bank fees, and angry merchants wanting to collect what you owe them. If you've ever gone through that experience, overdraft protection has an undeniable appeal. But before you rely on your bank's overdraft protection program, make sure you'll really get the protection you're paying for.
An offer you can't refuse
The ironic thing about overdraft protection is that the bank that's providing the service is the same one you need protection from. Without overdraft protection, if you don't have enough money in your account to cover a check, you'll generally have to pay at least two different fees: an insufficient funds fee charged by your own bank, and a returned check fee that the merchant who took your check will pass on to you. If you don't fix the problem quickly, you may end up paying these fees several times. Because of this, just one bad check can result in fees of $100 or more.
For those who make a habit of bouncing checks, things can get much worse in a hurry. Depending on the timing of checks and deposits, one bad check at the wrong time can cause other checks to bounce, multiplying those fees. Faced with the prospect of paying hundreds of dollars each month, consumers see overdraft protection as a financial life preserver.
Overdraft protection comes in several different types. With some programs, your bank opens a line of credit that you can draw against if you overdraw your checking account. You can expect to pay a fee each time you access your line of credit, and you'll have to pay interest on the amount you draw. If your bank offers this type of protection, make sure you know the limit on your line of credit -- you won't have any protection above that amount.
Other programs link your checking account to other accounts, such as savings, money market, or brokerage accounts. Again, the fees involved will vary by institution. Because it's your money in the other account, you won't have to pay interest, but you'll probably still pay a fee each time your bank makes a transfer because of a bad check.
For instance, Wells Fargo (NYSE: WFC ) offers both types of overdraft protection. With a line of credit, you'll pay a fee based on the particular credit agreement you sign. On the other hand, if you link your checking account to a savings account, the fee is just $10. And if you have a brokerage account as a link, you may not have to pay any fees at all.
Similarly, Citigroup (NYSE: C ) and its Citibank subsidiary charge just $5 for savings account transfers, compared to $30 for bounced checks. Bank of America (NYSE: BAC ) charges $10 for an overdraft protection transfer, less than its $20 or $35 charges for bad checks.
However, overdraft protection isn't always a bargain. Some banks, knowing that overdraft protection saves customers from having to pay returned check fees to their merchants, charge the same amount to cover overdrafts that they charge for bounced checks. Customers often pay these charges gratefully, as it saves them the embarrassment of bouncing a check and prevents any damage to their credit ratings.
Obviously, the best way to pay the least in overdraft-related fees is not to overdraw your account. If you're prone to making mistakes with your current account balance, or if you don't track it as closely as you should, keep some extra money in your checking account without including it in your balance. Even though that safety cushion won't earn interest, that's a small price to pay if it saves you from bad check fees even once.
But as a backup measure, an overdraft protection program can be a good idea. In general, you should opt for cheaper versions that transfer money from another account -- as long as you'll actually have money in that account. Credit lines are often more costly and have implications for your credit history. Whichever method you choose, it's important to see overdraft protection not as a safety net but as a tool of last resort.
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Fool contributor Dan Caplinger has never bounced a check, although he's had some close calls. He doesn't own shares of the companies mentioned in this article. Bank of America is an Income Investor recommendation. The Fool's disclosure policy won't bounce on you.