Overdrawing a bank account is when your balance goes below $0. It isn't ideal, but it can happen. Perhaps you forgot about an automatic payment or misjudged how much money you had. Or maybe you're having trouble juggling your bills and there isn't enough to see you through until payday.
If you overdraw your checking account, you'll usually need to pay a fee of some sort. If you regularly overdraw or stay overdrawn for a long time, your bank might close your account. The exact consequences depend on your bank, the type of transaction that sent you into the red, and whether you've opted in to overdraft coverage or protection.
The difference between overdraft protection and overdraft coverage
People used to be signed up for overdraft coverage automatically, but now it is something you have to agree to -- at least for debit card and ATM transactions. If you opt in, your bank will process a transaction, even if it sends you into the red. However, you'll be charged a fee for the privilege.
Research from the Consumer Financial Protection Bureau (CFPB) puts overdraft fees at between $10 and $36 per transaction for most top banks. Many cap the number of fees they'll charge each day. Some banks, including Citi and Capital One, have gone further and abolished overdraft fees altogether. Others offer cushions and grace periods to give customers a chance to avoid charges.
Some people use the terms "overdraft protection" and "overdraft coverage" synonymously. But several big banks draw an important distinction. Overdraft protection means your bank will transfer money from a linked account -- such as a savings account or credit card -- to cover the deficit.
There's often a fee involved, but it's usually less than the overdraft fee. For example, U.S. Bank's $12.50 overdraft protection transfer fee is almost a third of its $36 overdraft fee. Some banks, such as Bank of America and Wells Fargo, don't charge overdraft transfer fees.
How you can avoid overdraft fees
Even with limits on the number of daily overdraft transaction fees, overdraft costs can still add up quickly. Let's say your bank charges $35 per overdrawn transaction and has a cap of three fees per day. You use your debit card to buy groceries, not realizing your account is near $0. You buy a couple more items in another store and then stop for a coffee on the way home. Before you know it, you've racked up $105 in fees.
The good news is that there are ways to avoid overdraft fees. These include:
- Set up balance alerts: If you're not someone who regularly checks your bank account balance, a low balance alert could help you avoid an overdraft. Your bank will message you when your balance falls below a certain amount.
- Opt out of overdraft coverage: This will mean the bank rejects debit payments and ATM withdrawals that would take your balance below $0. You may still be charged if an automatic payment sends you overdrawn, but you're less likely to accidentally make multiple overdrawn transactions.
- Check your bank's overdraft policies: As we saw above, overdraft policies and fees vary wildly from bank to bank. Find out what your bank charges, and in what scenarios. For example, the U.S. Bank fees above only kick in if you overdraw by more than $50. It also has a grace period of a day to bring your balance back into credit.
- Choose a bank with customer-focused overdraft policies: Some banks have been more proactive than others in tackling overdrafts. If you worry about overdrawing, look for banks that don't charge overdraft fees. Other perks to watch out for include accounts that give you a grace period before charging you or a cushion that lets you overdraw slightly without penalty.
- Consider setting up a linked account: There are pros and cons to linking a savings account or credit card to your checking account. For example, if you link up your credit card, it may get treated as a cash advance, which could involve a fee and a higher interest rate.
- Give yourself a buffer: In my younger days, my head-in-the-sand approach to my money cost me a lot in overdraft fees. As a result, I now avoid automatic bill payments and always keep a buffer of around $300 in my checking account.
What happens if your account stays overdrawn?
Overdrawing occasionally could cost you in terms of fees. But as long as you bring your balance back into the black quickly, you're unlikely to face serious consequences. For example, overdrawing your bank account won't directly affect your credit score. Banks have a different system called ChexSystems that tracks things like overdrafts.
Unfortunately, if your account is overdrawn for a long period or you regularly slip into the red, the bank may close your account. In this scenario, it may send the money you owe to a debt collector, which would impact your credit. Plus, a low ChexSystems score could make it difficult to open a bank account.
In an ideal world, we'd all avoid overdrafts completely. Since we don't always live in an ideal world, take steps to minimize the impact of overdrawing. That might mean finding a bank that's gotten rid of overdraft fees or has a sizable buffer. Having an emergency fund will help avoid a prolonged overdraft, as you'll be able to funnel extra cash into your checking account if necessary.
