What is overdraft?

It can happen to just about anyone. You made a purchase, but you forgot to check the balance of your checking account, and now your account is in overdraft. To add insult to injury, your bank has now slapped you with some hefty overdraft fees. What exactly is an overdraft, and how can you avoid these additional fees?

Overdraft: A definition

Basically, an "overdraft" happens when you spend more money than you have. Each time a transaction exceeds your account balance, you experience an overdraft. Your bank or credit union will cover the cost of these transactions, though this money is treated as a loan that you're expected to pay back.

While an overdraft is never desirable, it ensures that your credit and debit card transactions go through even when you don't have sufficient available funds in your account. This processing ensures that you're still able to pay bills on time and avoid a full-scale halt to your spending.

However, your bank or credit union will also assess an overdraft fee. This fee makes overdrafts into costly mistakes and ones you should work to avoid.

How does overdraft work?

The existence of overdrafts might raise an obvious question: If you don't have the money in your account, why doesn't your bank simply decline the transaction? Actually, this is possible. Each time an overdraft occurs, your bank decides whether they will decline the purchase or cover the cost of the transaction. This decision is entirely at your bank's discretion, though usually, a bank pays for smaller purchases and declines larger ones.

Overdrafts occur more readily than you might expect. Here are some of the most common reasons an account holder can find themselves with a negative balance:

Automatic payments

Automatic payments are convenient for paying recurring bills, but they're also easy to forget about. If you don't have enough money in your account to cover this payment, the automatic payment becomes an overdraft.

Losing track of your funds

Mistakes happen. Sometimes an overdraft can occur when you make a credit or debit card purchase without checking your available balance. If it's a large purchase, your bank might not cover the transaction at all. When they do cover the purchase, you'll experience an overdraft and all of the fees that apply.

A check was deposited late

If you write someone a check, the recipient might not deposit the check until considerably later than you expect. You might have forgotten about this check in the interim, so your check will "bounce," and you'll experience an overdraft.

Credits not applied in time to cover transactions

Every financial institution will order transactions in different ways. This order means that your credits won't necessarily enter your available balance prior to your debits. For example, if your employer pays you through direct deposit, there can be a brief delay between the day you're paid and the day you have access to these funds.

Admittedly, this isn't very clear since your available balance won't necessarily reflect the chronological sequence of your transactions. Nevertheless, it's possible that your bank could withdraw a debit before a credit is applied, resulting in a negative account balance.

How do overdraft fees work?

When you don't have enough money in your account to cover withdrawals or transactions, you'll experience an overdraft. In addition to the amount of the original transaction, most banks and financial institutions charge fees each time you overdraft.

Declined transactions are typically not subject to overdraft fees. This distinction means that your bank can decline debit card purchases outright, and you'll avoid the costly fees associated with an overdraft.

However, some checks or purchases can be returned unpaid. When this happens, your bank may assess you a fee for "insufficient funds" (sometimes called "non-sufficient funds").

Again, every bank sets its own policies regarding these fees. But federal regulations require financial institutions to obtain your consent before adding an overdraft protection program that charges an overdraft fee to a credit or debit card transaction.

When you open a checking account or savings account, you have to opt into overdraft protection before your bank charges any fees.

Types of overdraft protection

Overdraft protection refers to the agreement you make with your bank to cover overdrafts on your checking account. This agreement also allows banks and credit unions to charge overdraft fees. When you sign up for a checking account, your bank will likely provide several options to choose from.

Here are some of the most common overdraft protection service options available today:

Standard overdraft coverage

The most basic form of overdraft protection covers basic transactions and recurring payments. This default form of coverage ensures that you're able to cover things like monthly memberships and subscription services. However, you may need additional overdraft protection for larger purchases.

The standard form of protection doesn't guarantee that your debit card transactions will all be approved. You can still have some transactions returned unpaid if you don't have enough money to cover them.

Linking your checking account and savings account

Some banks and credit unions will allow you to link your savings and checking accounts together. This way, when you don't have sufficient funds in your account, you'll automatically withdraw money from the linked account to cover the purchase.

Depending on your bank, there could still be a small transfer fee when withdrawing from your linked savings account. However, the transfer fee is usually preferable to other, larger overdraft fees.

Debit card coverage

Standard overdraft protection will allow recurring debit card transactions to go through, but not all transactions. If you still want to be able to make debit card transactions, your bank may offer this service. This approach allows you to spend money even when you have a negative account balance, though you'll be charged an overdraft fee for each transaction.

Debit card coverage should be seen as a convenience for use only in an emergency since the cost can really add up. Some banks may even place limits on how much you can spend when using this type of coverage, which protects you from getting in over your head.

Using a credit account

You can also pay overdrafts by connecting your bank account to a credit account. Some financial institutions already classify overdraft protection as a line of credit, which means you'll be paying interest when the bank pays for your purchases.

If you already have a personal line of credit, you can link this account to your checking account to form an overdraft line of credit. When you exceed your available balance, you'll automatically transfer money from your line of credit up to your available credit limit.

This setup can be a reliable way to ensure a positive balance, but you'll still be subject to your standard annual percentage rate (APR), so use this service wisely.

How to avoid overdrafts

Naturally, you'll want to avoid overdraft fees as much as possible. According to the Consumer Financial Protection Bureau (CFPB), overdraft fees and NSF fees cost Americans $17 billion in 2019 alone.

Since overdraft fees are an unnecessary expense, you can save money by learning to avoid them. Here are some of the most reliable ways to avoid overdrafts:

Rely on online banking

If you haven't already signed up for online banking, now's the time. The best online banking providers offer a variety of tools that you can use to monitor the money in your checking and savings accounts.

By using a secure app, you can check your account balance from anywhere in the world. This approach ensures that you always know if you have enough money in your account to cover a particular purchase.

Track your expenses

An online bank account makes it easier to keep track of your transactions. In addition to your available balance, you'll be able to see your recent transaction history.

But don't expect every transaction to appear on your bank statement right away. If you make a lot of frequent purchases, it's wise to have a tracking system or tracking app that will help you stay organized and avoid an overdrawn balance.

Sign up for balance alerts

Your bank or financial institution may offer account alerts that let you know when your bank account balance dips below a specific amount. Usually, you can specify this amount yourself. This way, when your account drops, you can manually transfer money from your savings account (or other checking accounts) to avoid a negative balance.

Transferring the funds yourself may also be cheaper than the transfer fees that you experience when using a linked account to cover your overdrafts.

Give yourself a cushion

Of course, the most reliable way to avoid overdraft fees is to ensure you maintain a positive account balance. Make sure your monthly budget includes a small "cushion" to protect yourself against overdrafts.

A smart idea might be to include enough money to cover one week's paycheck. This way, even if you go over your budget, you're not at risk of overdraft, nor do you have to dip into your hard-earned savings.

Use a credit card for emergencies

Depending on your credit card rates, it may be better to use a separate credit card for emergency spending. When you don't have enough money in your checking account, use a credit card instead of a debit card. If your rates are low, this might be a more affordable way to cover emergency expenses than relying on overdraft protection.

Business banking made simple

Overdrafts don't just happen to consumers. Business owners are vulnerable as well, and these overdraft fees can cut into your profits. One of the best ways to avoid this is by using an online business bank account.

Invoice2go offers a stellar banking platform that helps you keep track of your cash flow and allows your customers to pay you through automatic ACH transactions. Pay no fees for deposits, transfers, or minimum balances.

Try it for free. Sign up today, and you'll receive a 30-day free trial. You'll soon discover how the right technology can enhance your business processes and keep both your books and your bank accounts in the black.

Frequently asked questions

For specific questions about your fees or overdraft protection service, consult your bank or credit union. Here are some common questions that business owners and consumers ask about overdrafts: