Published in: Banks | Nov. 10, 2019

What Is Overdraft Protection?

By:  Kailey Hagen

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It lets you avoid embarrassment when you try to spend money you don't have, but it comes with its own costs.

Attempting to spend more money than you currently have in your checking account is called an overdraft.

When this happens, your bank will typically decline the transaction and may charge you a non-sufficient funds (NSF) fee. But that's embarrassing and could leave you in a bind if you need money in a hurry -- if your car breaks down and you need to pay to have it towed, for example. 

A woman holding shopping bags and looking at her phone.

Image source: Getty Images

There's a solution. It's called overdraft protection. When you sign up for it, your bank will permit your transactions to go through even if you don't have enough money in your account at the moment. But this strategy has a cost, too, and it can add up quickly.

How overdraft protection works

Banks used to automatically enroll customers in overdraft protection, but the government outlawed this practice in 2010. Now you must opt in to overdraft protection. 

There are a few options your bank might offer you, including the following:

  • Linking an eligible savings account: If you overdraw your checking account, your bank will automatically transfer money from a linked savings account to cover the overdrawn amount. It may charge a fee. 
  • Linking a credit card: If your checking account doesn't have sufficient funds, your bank will do a cash advance on your credit card to cover the transaction. There might be a fee and the cash advance will likely accrue interest at a higher rate than regular purchases. It may not have a grace period, either. Your bank may not offer this option depending on your creditworthiness, and it might only permit you to link to one of its own credit cards.
  • Overdraft coverage for one-time transactions: Your bank will allow your transactions to go through even if you don't have sufficient funds, but it will charge you a fee each time you do this.
  • Overdraft line of credit: Your bank assigns you a line of credit that's only used for overdrafts and is based on your creditworthiness. If you need to draw upon it, the bank will pay for your transaction, but the overdrawn amount and any associated fees begin accruing interest, much like a credit card, until you pay it back.

All of these strategies will ensure your transactions go through even if you don't have enough money in your checking account, but they all come with fees. More importantly, you'll pay those fees every time you overdraw your account. So, if you make a few small purchases without realizing you're overdrawn, you could rack up several overdraft fees before you know it.

And there are other limitations to overdraft protection that can hamper its usefulness. 

Limits on overdraft protection

Even with overdraft protection, your transaction could still get declined in some circumstances. And, depending on how many times you've overdrawn your account or how long it's been overdrawn, you could incur extra fees.

How much overdraft protection covers

When you link your savings account with your checking account, your overdraft protection is only as good as your saved cash. If you try to withdraw more than this, the transaction could still get declined.

Say you try to make a purchase that costs $250. If your checking account has $50 and your linked savings account has $150, that's still not enough to cover the full cost of the purchase, so your bank will decline the transaction and you'll get hit with an NSF fee.

Those who link a credit card or choose an overdraft line of credit can only charge up to their credit limit. If they exceed this amount, the transaction will get declined. If you opt in to overdraft protection for one-time purchases, your bank may set a flat dollar amount that you can't exceed in overdraft charges. 

How many times you can overdraw an account

Some banks may limit the number of times you can overdraw an account in a day or a month, but usually there's no limit as long as you don't exceed the credit limit or overdraft protection limit set by your bank. 

One thing to remember if you link a savings account to your checking account for overdraft protection: You're limited to six transfers or withdrawals per month by federal law. This includes transfers or withdrawals you make that have nothing to do with overdrafts. Exceed this limit and you'll incur a savings withdrawal limit fee on top of your overdraft fee. 

Some banks limit the number of overdraft fees they'll charge you in one day, while others will charge you for every single transaction until you put more money in your account.

How long your account can be overdrawn

Your bank should give you at least a few days to pay back what you owe before taking further action, but if your account remains overdrawn for several weeks, your bank might charge you an extended overdraft fee.

After an amount of time, which can vary by bank, it will close your account and report you to a collections agency. It'll also send a negative report to ChexSystems. This is a credit reporting agency that keeps track of closed bank accounts, bounced checks, and account overdrafts. This could prevent you from opening a new checking account for at least five years.

Overdraft fees

Overdraft fees vary by bank and by the type of overdraft protection you choose.

When you link a credit card or savings account, the fees are lower -- usually $10 to $12 per transaction. If you use a credit card, your card issuer will also charge you for a cash advance. Those with overdraft protection for one-time purchases could pay $30 to $35 per transaction. And those with an overdraft line of credit may also pay a $10-to-$12 fee per transaction, plus they'll have a balance with an APR around 20%.

In contrast, the NSF fee you might incur if you didn’t have overdraft protection will probably be somewhere around $35 per transaction -- and that’s after having the transaction declined.

The amount you'll pay in overdraft fees depends in part on how your bank orders your transactions.

It can debit them from your account in the order you made the purchases, in which case you'd pay an overdraft fee on the first purchase that brought your balance below zero and every one thereafter.

Or it can debit all of your purchases in one day in order from largest to smallest. In this case, it'll debit the most expensive item first, regardless of when you purchased it that day, and then the next-most expensive item, and so on until you get to the least expensive item you bought that day.

This strategy could lead to a lot more overdraft fees. Consider the following scenario: Your bank account has $200 in it. You buy a $5 item, a $10 item, a $25 item, and a $200 item before you realize you've overdrawn your account.

If your bank used the chronological approach, you'd only pay an overdraft fee on that final purchase because you had enough money in your bank account to cover the three smaller purchases.

But if your bank debits your purchases in order from largest to smallest, you wouldn't pay an overdraft fee on the $200 purchase because your account had sufficient funds -- but you would pay three separate overdraft fees on each of the three smaller purchases you made earlier in the day. 

Is overdraft protection worth it?

Overdraft protection can be useful in select circumstances, but it can also be costly, especially if you rack up several overdraft fees in a single day. You can enroll in overdraft protection if it gives you peace of mind knowing that your transactions likely won't get declined even if you don't have enough money, but make sure you understand all the terms first. Know the limitations and fees, and understand which method your bank uses to debit purchases from your account.

The best thing to do is avoid overdrawing your account whenever possible. Try some of these tips:

  • Monitor your spending. Keep track of your spending in a budgeting app or look over your transaction history on your bank's website or mobile app and avoid unnecessary spending when your balance is low.
  • Sign up for account alerts. Many banks offer account alerts that notify you of a low balance so you can avoid accidentally overspending.
  • Review your account balances. When you know you don't have a lot of money in your account, check your account balance before making a purchase to see if you have sufficient funds.

Overdraft protection isn't inherently good or evil. It can be either depending on your situation.

Having a thorough understanding of how it works will help you decide whether it's a good fit for you, but when in doubt, consider staying away and monitoring your spending more closely so you don't have to worry about needing overdraft protection.

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