Credit Demystified – Chapter 1, Section 4: Overdrafts & Overdraft Protection

For many people, the decision to avoid using a credit card and making all purchases with their debit card instead is driven by one factor: debt avoidance.

Given the statistics around credit card debt, that decision is entirely understandable.

But if you’re going to rely on your bank to keep you out of debt, make sure you understand your bank’s policies. Some banks will let you go into overdraft. Meaning that if they are presented a permission slip (debit charge) from a merchant but your bank balance isn’t sufficient to cover the charge, the bank will pay the merchant on your behalf. And they’ll charge you a fee for doing so.

Banks’ overdraft policies can make it very difficult to recover and get back on solid financial ground once you find yourself in overdraft. It’s a trap that can be as financially devastating and as difficult to climb out of as any other form of consumer debt.

If you overdraft your checking account, not only do you now have an extra fee to pay but the bank will usually prioritize overdrafts (debt to the bank) and their fees over any other debit charges you’ve made or checks you’ve written. And to complicate things just a little more, the order in which your bank processes transactions can add to your miseries.

Let’s say you have overdraft protection on your checking account. And you miscalculate your account balance. You thought you had $105 left but you really only have a balance of $99. You make a grocery run and purchase $100 worth of ramen, chips, frozen tacquitos, and toothpaste. The bank will honor the $100 permission slip submitted by the merchant. You now owe the bank that extra $1.

$99 – $100 = -$1

But they don’t do this because they like you and share your passion for tacquitos. They do this because they make a lot of money from charging fees.

Your bank will “lend” you $1, pay the merchant the full $100, and charge you a $35* overdraft fee. That $1 deficit is suddenly a $36 debt.

Continuing with the scenario, later that night you make a quick run to pick up your prescripiton ($10) and stop for a midnight milkshake ($5) too. Again, your bank will honor the $5 permission slip for the milkshake and add their $35 overdraft fee. Now you’re $76 in the red. Add in the $10 prescription (plus another overdraft fee) suddenly you’re $121 in the hole.

($1 + $5 + $10) + ($35 x 3) = $121

$16 [debits] + $105 [fees] = $121

Okay, this all looks awful but let’s say that, luckily, tomorrow is payday and your employer pays via direct deposit.

Timing, and your bank’s policies, will play critical roles in what happens next.

In the above scenario (a full day between clearing overdraft debits and receiving new deposits), the timeline is clear. Your bank will apply your deposit and immediately subtract the overdraft fees you owe. Then they’ll subtract the total of the overdrafts. If no other transactions clear, your balance at the end of the day will be your paycheck less the fees and overdrafts.

deposit – fees – overdrafts = remaining balance

In a worst case situation — your paycheck isn’t sufficient to cover both the fees and the overdraft debit amounts — the bank will take their fees first, then take the rest to cover the overdrafts, leaving you with no money and an outstanding debt. Any new debits or withdrawals will immediately trigger new overdrafts and new overdraft fees. You can see where the fees could quickly add up to such an extent that digging out of the hole would seem nearly impossible.

In the above situation, the costs are ugly but the order is clear: fees first, then overdraft amounts.

But it’s a little more complex than that when deposits, transactions, and overdrafts all happen on the same day. Each bank sets their own policies on processing order. Most banks apply different policies depending on the type of transaction. So ATM transactions might be considered differently than checks and recurring debit transactions might be subject to different handling policies than point-of-sale debit charges.

Let’s say that instead of initiating payroll overnight, your employer pays with a check that you’ll deposit on your lunch hour. Or they initiate electronic payroll during normal business hours on payday. In either case, your deposit won’t be made until well into business hours — long after overnight debits were processed. In that case, even if you deposit a big chunk of money, your overnight purchases will be overdrafts and you will be assessed a fee for each one.

Even if your employer processes payroll automatically in the early morning hours on payday and the deposit shows up before you even go in to work, that might not save you from overdraft fees for overnight debits. Many banks have a 9am grace period (if the deposit is made before 9am, overdrafts are forgiven) but the fine print often includes several caveats including past behavior and the type of transaction. If you make a habit of overdrafting, your bank may choose to run transactions in exact order — processing the debits first which would trigger overdraft amounts and overdraft fees before applying your deposit.

A worst case scenario would look something like this:

It’s the end of the month. You made a calculation error and spent $1 more on groceries than you had available. You knew your paycheck would hit the bank tomorrow so you picked up your prescription and stopped for a milkshake. Those three transactions sent you into overdraft because your bank processed the debits before your paycheck cleared. Your bank will immediately deduct the $105 in fees and the $16 in overdrafts. And, since it’s the 1st of the month, your automatic payments for your rent, car payment, your student loan all process that afternoon. Under normal circumstances, those payments would have cleared — the total amount of debits would not have exceeded your deposit amount. You would have been left with just enough to get you through to the next paycheck. But the additional burden of the overdraft fees tipped you back into the red and you’re trapped in another overdraft cycle before you ever actually got out of the last one.

All this to say, it is possible to go into debt with a debit card.

But wait…

There’s one more feature of overdraft protection that I need to scare tell you about: your savings account. Many banks will “offer” to connect your checking account to your savings account as a backup source of funding in case of overdrafts. If your bank is presented with a debit charge, check, or automatic withdrawal that will overdraft your checking account, they will pull the necessary funds from your savings account to cover the charge. Some banks will do this without charging a fee, some will do it for free X number of times before assessing a fee, and others will charge a fee every single time.

So is overdraft protection always a bad idea? Well, it depends.

If debt avoidance is a significant reason you’re using debit instead of credit then overdraft protection would probably be self-defeating.

Without overdraft protection, the initial $100 debit charge for groceries would have been declined at the register and you could have decided to put back the tube of toothpaste (and, if truly desperate, maybe the tacquitos). And after spending $97 at the grocery store, the $5 milkshake and $10 prescription charges would also have been declined at the register.

But sometimes the damage done by your bank declining a transaction is worse than having your bank allow the overdraft. In the case of checks you write or recurring transactions for things like your rent, car payment, or student loan payments, if you don’t have the funds and you don’t have overdraft protection, the bank will decline payment due to insufficient funds.

All of those places will levy a hefty fee if your payment doesn’t clear. And your bank will hit you with an NSF (non-sufficient funds) fee. Now, instead of a single $35 overdraft fee, you might be facing a $35 fee from your bank and another fee from your landlord. Those fees can and will add up and you could find yourself owing more money to your landlord, your auto lender, and your school loan provider than you can realistically pay. Plus you still owe them the original payment. Even worse, you could be facing eviction, repossession, and severe penalties if you miss a payment.

To be clear, spending more than what you have in the bank is, at best, a bad idea and, at worst, a criminal act. The advantage of overdraft protection is that it limits your overspending and fees to a single source — your bank. An occasional overdraft will cost you an overdraft fee but it won’t ruin your reputation and credibility with merchants and your landlord. So if you prefer to use a debit card, understand the risks, don’t rely on your bank to keep you from going into debt, and overdraft protection would bring you peace of mind — then go for it.

It really is important that you read the fine print on your bank accounts, your loans, your lease agreements, etc. It’s equally important that you know yourself – your weaknesses, your habits, your unique situation and make an informed decision about whether overdraft protection would serve in your best interests.

*As with all fees, overdraft fees vary from bank to bank. As of this writing, Wells Fargo states a $35 per overdraft fee while CapitalOne states their fee is $9 per overdraft.

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