Overdraft
What Is an Overdraft?
An overdraft is an extension of credit from a lending institution that is granted when an account
reaches zero. The overdraft allows the account holder to continue withdrawing money even when
the account has no funds in it or has insufficient funds to cover the amount of the withdrawal.
Basically, an overdraft means that the bank allows customers to borrow a set amount of money.
There is interest on the loan, and there is typically a fee per overdraft. At many banks, an
overdraft fee can run upwards of $35.
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Overdraft
How an Overdraft Works
With an overdraft account, a bank is covering payments a customer has made that would
otherwise be rejected, or in the case of actual checks, would bounce and be returned without
payment.
KEY TAKEAWAYS
Overdraft protection is a loan provided by some banks to customers when their account
reaches zero.
The overdraft allows the customer to continue paying bills even when there is insufficient
money in the customer's account(s).
An overdraft is like any other loan, the customer pays interest on the loan and, in the case
of overdrafts, will typically have a one-time insufficient funds fee.
As with any loan, the borrower pays interest on the outstanding balance of an overdraft loan.
Often, the interest on the loan is lower than the interest on credit cards, making the overdraft a
better short-term option in an emergency. In many cases, there are additional fees for using
overdraft protection that reduce the amount available to cover your checks, such as insufficient
funds fees per check or withdrawal.
An Example of Overdraft Protection
Overdraft protection provides the customer with a valuable tool to manage their checking
account. If you're short a few dollars on your rent payment, overdraft protection ensures that you
won't have a check returned against insufficient funds, which would reflect poorly on your
ability to pay. However, banks provide the service because of how they benefit from it—namely,
by charging a fee. As such, customers should be sure to use the overdraft protection sparingly
and only in an emergency.
The dollar amount of overdraft protection varies by account and by the bank. There are pros and
cons to using overdraft protection. Often, the customer needs to request the addition of overdraft
protection. If the overdraft protection is used excessively, the financial institution can remove the
protection from the account.
Special Considerations
Your bank can opt to use its own funds to cover your overdraft. Another option is to link the
overdraft to a credit card. If the bank uses its own funds to cover your overdraft, it typically
won't affect your credit score. When a credit card is used for the overdraft protection, it's
possible that you can increase your debt to the point where it could affect your credit score.
However, this won't show up as a problem with overdrafts on your checking accounts.
If you don't pay your overdrafts back in a predetermined amount of time, your bank can turn
over your account to a collection agency. This collection action can affect your credit score and
get reported to the three main credit agencies: Equifax, Experian, and TransUnion. It depends on
how the account is reported to the agencies as to whether it shows up as a problem with an
overdraft on a checking account.