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Attempting to spend more money than you currently have in your checking account is called an overdraft. Normally, your bank or credit union just declines the transaction and may charge an insufficient funds fee. But if you'd rather the transaction went through anyway, you can opt into overdraft protection. Here's a closer look at what that is and how it works.
Overdraft protection helps you fund purchases when you don't have the cash immediately, but it can be costly. Banks used to auto-enroll customers in overdraft coverage, but the government now requires you to opt into this service.
Your bank could offer you any of the following overdraft protection options:
All of these methods come at a cost and you'll pay a fee for every single overdraft. That can be costly, especially if you make several purchases before realizing you've overdrawn your account. There are also other limitations to overdraft protection.
Overdraft protection has a few drawbacks other than cost that you should be aware of.
If you have a linked savings account, you could still wind up with an NSF fee and a declined transaction if you don't have sufficient funds in your savings account to cover the overdraft. The same thing is true if you have a linked credit card or an overdraft line of credit and you exceed your credit limit.
Some banks limit the number of overdraft fees they'll charge you in a day or month, but many do not. Ask your bank if you're unsure how it handles this.
If you have a linked savings account and overdraw your account repeatedly, you could face penalties for making more than six savings account withdrawals per month. However, this rule is not in place during the pandemic.
If your account remains overdrawn for several weeks, your bank may charge you an extended overdraft fee on top of the initial overdraft fees.
It could also report you to a collections agency and ChexSystems, the reporting agency that tracks how responsibly you've managed your bank accounts in the past.
Your overdraft fees depend on your bank and method of overdraft protection. You may only pay $10 to $12 per overdraft for linking a savings account, credit card, or line of credit, while you could pay $35 or more if your bank charges you a per-transaction fee. Overdraft lines of credit and linked credit card balances will also accrue interest. In contrast, the NSF fee you could pay if you didn't have overdraft protection would be around $35.
How much you pay also depends on how your bank orders your transactions. Some use the chronological approach, which records your purchases in the order you made them, while others order your daily purchases from largest to smallest
If you have $200 in your checking account and you use your debit card to make a $5, a $10, a $25, and a $200 purchase before you realize you've overdrawn your account, you'd only pay a single overdraft fee for the $200 purchase if your bank used the chronological approach. But you'd pay three separate fees for the three smaller items if your bank ordered your purchases from smallest to largest.
Your bank's overdraft protection service can definitely be useful if you find yourself in a bind where you need cash immediately in an emergency, but it can also get costly fast. If you're considering opting in, know your bank's overdraft protection options and any associated fees and make sure you're comfortable with them.
Even better, avoid overdrafts altogether. Here are some tips:
Overdraft protection isn't inherently good or evil. It can be either depending on your situation. Having a thorough understanding of how it works is key to knowing whether it's right for you. But when in doubt, it's better to skip overdraft protection and just keep an eye on your balances.
Here are some other questions we've answered:
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