What Is Overdraft Protection?
Benilyn has over a decade of experience as a banking officer. Her expertise is featured throughout Fit Small Business in personal finance, credit card, and real estate investing content.
This article is part of a larger series on Business Banking.
Overdraft protection is a term that refers to an optional service offered by banks to protect depositors against non-sufficient funds (NSF). For a fee, the bank will cover your financial transactions that exceed the funds in your account. Overdraft protection is an essential service if you need all your financial transactions to go through successfully.
How Does Overdraft Protection Work?
Overdraft protection works as a cushion for your checking or savings account. When enrolled, the bank covers your financial transactions against an account with an insufficient balance. Overdraft protection is an optional service that is usually offered by banks when you open a bank account.
Typically, banks charge an annual enrollment fee when you join an overdraft protection program. This service kicks in when you have a financial transaction that is greater than your available account balance. When this happens, the bank charges a fee per incident. It’s important to read and understand the bank’s overdraft protection agreement as banks reserve the right to reject transactions that don’t comply with the rules stated in the agreement.
To help understand how this protection works, let’s say you wrote a $1,000 check to pay a supplier, but your account balance is only $800, and you also forgot to make a deposit. Since you have enrolled in your bank’s program, instead of having your check bounced due to insufficient balance, your overdraft protection kicks in to cover the shortfall. The bank then charges you a fee for this incident, and you’ll also need to pay for the balance covered by the bank.
Without overdraft protection, your check will most likely bounce due to insufficient funds (NSF), and the bank will typically charge you with NSF fees. Furthermore, you also risk hurting your credit record with your supplier. To avoid this, it’s best to opt-in your bank’s overdraft protection program upon account opening.
Types of Overdraft Protection Programs
There are different types of overdraft programs provided by banks and financial institutions. These programs can help you cover your financial transactions against an insufficient balance. Typically, banks charge an enrollment fee and a fee per incident.
The different types of overdraft protection programs include linking to another deposit account, linking to a credit card, overdraft protection line of credit, and a courtesy overdraft program.
Linking to Another Deposit Account
One of the most common types of overdraft protection involves linking your checking account to another deposit account at the same bank. If your available checking account balance is not sufficient to cover a check, the bank authorizes a funds transfer from your linked account to cover the transaction. Often, banks charge a fee for every transfer to cover a transaction against an insufficient balance.
Linking to a Credit Card
Some banks allow you to link a credit card to your checking account so that when there is a transaction that is more than your available account balance, the linked credit card can cover the insufficient amount. Typically, the bank charges a fee per incident. Additionally, cash advance fees and corresponding interests specific to your cardholder agreement shall apply.
Overdraft Protection Line of Credit
Many banks offer an overdraft protection service that acts as a line of credit for an additional annual fee. A line of credit is a loan designed specifically to cover transactions that overdraw your account. Banks charge a fee per transaction and interest on the amount of the line of credit that is used.
Courtesy Overdraft Program
A courtesy overdraft is letting the bank temporarily cover the transaction against insufficient funds. If you choose to opt-in to this type of protection service, the bank covers your overdrawn ATM withdrawals and debit card purchases. This transaction results in a negative account balance. An overdraft fee is charged for every transaction, and you may also be charged with additional fees in the event you don’t pay the overdrawn amount within a specified period of time.
Who Needs Overdraft Protection?
Both business and consumer checking account holders can benefit from overdraft protection. If you issue important check payments regularly, such as payments for suppliers and lessors, you need to be certain these payments are covered. To ensure that you avoid any incidents of bouncing checks, getting extra protection through opting-in to your bank’s overdraft protection program is a sound business decision.
If your account cannot issue checks, there may be no need for overdraft protection. For some people, it would be better to let the bank decline transactions against an insufficient account balance, such as ATM withdrawals and debit transaction purchases, rather than have these transactions go through and pay hefty fees later.
How to Qualify for Overdraft Protection Service
Banks usually offer overdraft protection to their selected customers upon account opening. The requirements to qualify for this type of program may vary from bank to bank. In general, you must already have an existing account with the bank or open an additional account to enroll. Typically, banks offer this optional service to existing clients they deem creditworthy.
Pros & Cons of Overdraft Protection
| PROS | CONS |
|---|---|
| Your transaction won't be declined even if you don’t have enough funds in your account | You will pay an enrollment fee, fee per incident, and corresponding interest charges |
| Avoid returned check fees | Fees can add up, especially if you have multiple insufficient transactions |
| Avoid the risk of bouncing checks and hurting your credit record | Transactions may not clear if your backup account’s balance is insufficient or the transactions didn't comply with the rules stated in the agreement |
| Prevent any embarrassment due to returned checks or declined transactions at the checkout line | You might end up overspending, thinking that you your expenses are covered |
Tips to Manage Your Account Efficiently
While getting overdraft protection can help you avoid bouncing checks and risking your credit, it’s still important not to always rely on it. Knowing how to manage your accounts and expenses efficiently is the best solution to prevent financial transactions against insufficient funds.
Here are a few simple account management tips to help you avoid overdrawing your account:
- Monitor your account balances: For checking accounts, you need to ensure that you balance your checkbooks regularly. Make sure you have enough funds in your account to cover all the checks that you write. For savings accounts, make sure to know your exact available balance before making ATM withdrawals and debit purchases.
- Make use of online and mobile banking: Most banks offer online and mobile banking options so that you can easily monitor your balances anytime and anywhere. Take advantage of this technology to ensure that you have sufficient account balances and avoid overspending.
- Have a cash reserve in your checking account as a cushion: Instead of relying on overdraft protection, it’s better to deposit extra funds in your account to be used as a cushion in case of emergencies. Once used, make sure to replenish the same amount of money, and don’t touch it unless extremely necessary.
- Avoid overspending: It’s essential that you don’t spend the money you don’t have. One of the easiest ways to avoid overspending is to not sign up for overdraft protection for debit transactions. Having your debit purchases declined when you don’t have enough funds in your account is better than getting charged with overdraft fees.
Bottom Line
Overdraft protection is an optional service provided by banks to help prevent bouncing checks and declined financial transactions due to an insufficient account balance. Usually, it is offered to qualified clients who are creditworthy and comes with corresponding fees and interest charges. Ask your bank representative to find out if your bank offers an overdraft protection service.
