Many people are not even remotely familiar with this financial term and the importance behind it. They often assume that overdrafts and other similar products like “bounce protection” and “overdraft protection transfer” are just the same thing. However, they’re not! But what are overdrafts and why are they so important in your everyday life?
By definition, overdrafts are a type of loan that transfers funds from your checking account to cover purchases when you don’t have enough in your account at the time of making a purchase.
This can be a helpful tool for covering emergencies or small purchases when you don’t want to deal with having insufficient funds in your account to cover something important like rent or food.
In this article, we will provide you with all the needed information on this important topic.
What Exactly Is an Overdraft?
An overdraft occurs when you don’t have enough money in your checking account to cover a transaction you initiated. Instead of declining the transaction, banks and credit unions will allow you to do it anyway, charging you overdraft fees. Even though they can be useful in times of emergency, these bank overdrafts are often expensive and require good financial management.
The most common reason for an overdraft is when a check or automatic bill payment clears before your deposit arrives, causing you to spend more money than what’s in your account.
Now that you know what they are, let’s take a look at how do overdrafts work.
How Do Overdrafts Work?
When you overdraw your account, the bank will allow you to borrow money and be charged a fee for doing so. This is not the same thing as having a line of credit because you must repay the amount within a few days (usually five or six days) or else they will charge you another fee.
An overdraft loan can be useful if you need cash quickly and don’t have time to wait for a check or ACH transfer from another account (or if those options aren’t available). However, interest fees are really high and can easily trap you in a cycle of debt if they are not paid within a short period of time.
How to Apply for an Overdraft
To apply for an overdraft, go to your bank’s website and fill out the application form. You can also apply for it in person if that is something you prefer. There are many banks that allow overdrafts because that is a fast way for them to make money, but just because yours allows it, doesn’t mean you need it.
In case you are someone who doesn’t have a close watch over their spending or does not check their account regularly, it may be better for you to avoid this.
If you are denied, it’s possible that your credit score could be too low for approval so be sure to talk to someone before applying again.
Types of Overdrafts
There are two main types of overdrafts you should be aware of- authorized and unauthorized.
You can get an authorized overdraft if there’s money available in another linked account you have within the same bank, like a savings account.
An unauthorized overdraft occurs when you spend more than what’s available in both accounts combined.
Let’s take a bit more in-depth look at both so you understand them even better.
An authorized overdraft happens when you overdraw your account, but the bank or credit union pays the transaction and charges a fee for it. This may seem like a bad thing at first, but this is actually a great way to avoid bounced check fees!
If you have previously filed for an authorized overdraft with your bank or credit union and later on make one of these transactions when your balance is too low, they’ll cover it. You can set up this service by contacting the institution you have an open account with and asking them about their policies on this type of advantage.
If you are charged a fee for an overdraft that was not authorized by you, then it is considered an unauthorized overdraft. To give you an example, if someone uses your debit card to make a purchase and the transaction is declined because there are not enough funds in the account but they continue to use the card anyway, then this would be considered an unauthorized debit card overdraft.
Another example would be if someone made multiple purchases with your card and those transactions were processed by your bank even though there was not enough money in your account at that time.
In order for a financial institution to charge you for these unauthorized debit card overdrafts, they must first notify you of this fee ahead of time through email or text message so you know what you are being charged for.
Overdrafts: Pros and Cons
Overdraft is still a type of loan, and like any other, has its own set of both positive and negative sides. It is important to know about both so that once it comes to making a decision about whether you need one or not, you can choose what’s best for you and your personal situation.
Overdrafts can be a good thing if you’re careful about how you use them. They can give you the power to use your checking account much like a credit card.
Overdrafts can be a bad thing, too, as they are quite expensive practices. The average fee is about $40 per transaction. Plus, even if you don’t have any fees attached, there’s still no guarantee that your bank won’t charge interest on what they loaned out anyway.
- It is convenient. You are essentially able to withdraw cash from an ATM anywhere, anytime without worrying about whether your account is low on funds.
- They can help you avoid bounced checks and late fees. If you’re writing a check without enough money in your account, there’s a good chance it will bounce when it gets deposited and charged around $30 per check. In case this happens too often to you, it could affect your ability to open new accounts in the future.
- There is certain flexibility. You can make a transaction any time at any amount you need, up to a certain limit set beforehand of course.
- Can be really expensive. If you don’t pay your balance in full, the bank will charge you interest on the amount of your overdraft. If you don’t pay this back, it will continue to grow.
- Possibility or limit reduction if used excessively and not paid back on time.
- The interest rate applied is variable so it can be difficult to predict the total cost.
How to Pay Off Overdrafts
There are several ways to pay off overdrafts, depending on your financial situation.
If you’re looking for an easy way out of this you could just go ahead and use your savings to pay it off. In case you don’t want to wait for your next payday to come around and don’t have much in savings, it may make sense for you to take out a personal loan instead.
While using a personal loan or HELOC is generally considered more expensive than having an overdraft at a bank, the interest rates associated with these loans tend not to be as high as those charged by credit cards or payday loans.
Do Overdrafts Affect Your Credit Score?
You may be confused and questioning: do overdrafts affect credit scores?
In short, it is true that having a few overdrafts on your account can lower your credit score by as much as 30 points (and thus make it harder to get approved for loans), but there are some things you can do to avoid negative impacts on your credit report.
First of all, once these overdrafts happen be sure to pay them off as soon as possible. Additionally, pay them in full if you can afford to do so.
Depending on the bank you chose will also depend how many overdrafts you can have as well as the fees charged for these actions. So, if you are someone that often overdrafts the account choose a good bank that will charge less than other ones.
How to Avoid Overdraft Fees
- Avoid using your debit card. If you do use your debit card, make sure the transaction is authorized with a PIN or signature.
- Set up overdraft protection with your bank or credit union. This should be done before you ever go into overdraft so that payments are made automatically if there are insufficient funds in your account.
- Use direct deposit whenever possible so that bills are paid by their due date and there aren’t any late fees added to them. If possible, try to set up automatic bill pay through online banking services.
- Keep a close watch on your account and spending so overdrafts never happen in the first place.
In conclusion, overdrafts can be a useful way to pay for unexpected expenses, but they can also be a source of constant frustration. They’re expensive and time-consuming, which is why many people decide against using them altogether.
Nonetheless, they can be helpful if you need to cover expenses you maybe forgot to budget in and as long as you pay off your balance quickly and don’t incur any additional fees you should be just fine.
If you are unsure whether overdrafts fit your budget and whether or not you need them, you can always just go ahead and schedule a meeting with a financial advisor to get guidance in the time of need.