We all make mistakes. Sometimes those mistakes involve writing a check for money that isn’t available in our bank account. If you face this risk, you’ll want to know about overdraft protection plans.
Note that banks used to automatically add this feature to all checking accounts. Nowadays, it's an opt-in thing: you need to request it if you want it, and you might not want it (overdraft protection can be expensive and many people are better off without it).
Overdraft Protection Overview
If you have overdraft protection on your account, the bank will cover the check (or pay the money) for you. Let’s assume that you write a check for $100 and you don’t have $100 in the bank. The bank might allow the check to clear, and simply expect that you pay back the $100 later.
Of course, there are limits. You’ll find different limits on the dollar amount that an overdraft protection plan will cover. Also, you may have your privileges revoked if you frequently write checks in excess of your available balance.
The Cost of Overdraft Protection
Banks don't do this for free. They charge fees partly to keep you from abusing the service, and (not surprisingly) it creates a source of revenue for the bank. Make sure you know what the charges will be if you’re going to add an overdraft protection feature to your account. Typically it will be similar to the Non-Sufficient-Funds fee.
Next, there may be interest costs. Depending on your overdraft protection plan, the amount of your overdraft might be considered a “loan”. In that case, the bank charges interest until you repay. This option (known as an overdraft line of credit) is usually less expensive than paying a flat fee for each overdraft that hits your account.
Finally, remember the bigger picture. If you use overdraft protection too often, it means you’re getting into bad habits that will cost a lot over your lifetime. It’s a sign that you haven’t managed your cash-flow well. Although bounced checks don't show up on your credit report, they can affect how small banks and credit unions evaluate your creditworthiness.
Overdraft Protection Pros and Cons
Let’s focus on the most important thing: it costs money to have overdrafts. Obviously, the reason you had one is because you didn’t have enough money available, and now you have less. You can see how overdraft protection does not help you in the long run.
The main benefit of overdraft protection is that the party you wrote the check to is not aware that you were short on cash when you wrote the check. This keeps you from becoming embarrassed if you wrote the check to a friend or business partner.
The other benefit that is worth mentioning is that you can avoid bounced check fees from the retailer. If you don’t have overdraft protection, you may have to pay a fee to your bank (Non-Sufficient Funds or NSF) and an additional fee (Returned-Check) to the retailer. Ultimately, you can end up with negative reports in your ChexSystems file.