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Understanding Overdraft Protection: What it is and how it can help you.

in Managing Money & Credit
understanding overdraft protenction

At one point or another, many of us have had overdrawn accounts due to a slight oversight in our budgeting, delay in a check deposit, or just simply not having enough funds to cover expenses. Overdrawing your account can be embarrassing, but more importantly can impact your financial health if you don’t have the right safeguards in place. Fortunately, there are things you can do to prevent overdrawing your account from happening to you.

What is Overdraft Protection?

Overdraft protection is a service offered by a credit union or bank that covers any shortfall you may have if your checking account is overdrawn (up to a certain limit). Essentially, your financial institution will cover a transaction that then brings your account balance below zero—up to a certain limit—with the idea that you will pay this amount back in addition to a fee for the service.

Without overdraft protection, your financial institution will not cover your transaction if your account is overdrawn. Furthermore, they will likely charge you a non-sufficient funds fee (NSF).

Here’s an example of how overdraft protection works:

Imagine you have $250 in your account. You forget that your electricity bill of $200 will automatically be deducted on today’s date. That night, you also pick up a $100 dinner tab with your best friend, who promises to transfer you their portion of the bill ($50) next week when she gets paid.

Since your account balance is lower than the amount being withdrawn, you don’t have sufficient funds in your account to pick up the entire bill. However, if you have overdraft protection, your credit union or bank will cover the amount needed to pay the bill, leaving you with a balance of -$50 (plus the amount of the overdraft fee).

Without overdraft protection in place, you would be charged an NSF fee, and your financial institution wouldn’t cover the cost of your transaction(s). This means that the restaurant will decline your card and you will still have to pay a fee to your financial institution.

Overdraft Protection Fees

Most financial institutions charge an overdraft protection fee for the service. This fee could be assessed at the end of the month or per use (only when you overdraw your account). At Lafayette Federal, we only charge you a nominal fee when you use the service. In other words, you don’t have to pay a fee simply for opting into overdraft protection.

Overdraft protection fees can range from $5 to as much as $38 per item. Some financial institutions may even charge interest on any balance outstanding, if you are linking your account to a line of credit (more on that later).

Nonsufficient Funds (NSF) Fees

Overdraft fees and NSF fees are both related to an overdrawn account but are fundamentally different. While overdraft fees are charged for the use of overdraft protection services, NSF fees are charged when your financial institution declines to cover a transaction that exceeds your current balance.

It’s important to note that even if you have overdraft protection, you can still be charged an NSF fee if you pass your overdraft protection limit. Either way, trying to make a transaction when you don’t have enough funds in your account can result in an expensive fee, so staying on top of your finances is the best practice to efficiently managing your money.

Types of Overdraft Protection

There are two main types of overdraft protection: opt-in overdraft protection and linked account protection.

Opt-In Overdraft Protection

Opt-in overdraft protection is the most common type of overdraft protection. Before 2010, banks could automatically provide overdraft protection to you. They must now get your permission before covering a transaction that would put you into overdraft.

When you opt in to overdraft protection, your financial institution will lend you enough money to cover a transaction (or multiple transactions) up to an approved limit. Your responsibility is then to deposit enough money into your account to bring your account balance back to zero and pay your overdraft fees.

Linked Account Protection

By linking your bank account to another account, such as a savings account, your financial institution can transfer money from your linked account to cover the amount of the overdraft. In addition to savings accounts, you may be able to link your account to a credit card account or a line of credit attached to your checking account.

You may be charged a small fee each time this service is used, but this fee is often less expensive than other types of overdraft protection.

Why Would I Need Overdraft Protection?

Overdraft protection should not be seen as a permanent solution to your financial problems, but rather a “last line of defense” if you overextend yourself financially. More than anything, overdraft protection is for peace of mind. With that being said, overdraft protection does offer some benefits to account holders.

Emergency Coverage

It is always a good idea to have an emergency fund if something unexpected happens. Car troubles, unplanned travel expenses, and home repairs are a few unforeseen events that may require you to come up with cash quickly. An emergency fund helps you stay prepared for these unexpected expenses.

But if multiple emergencies happen at once, your backup funds may not cover everything. As a result, you may not have sufficient funds in a checking account to immediately cover any shortfalls. If you have already exhausted your emergency fund, overdraft protection can at least ensure partial coverage for any financial surprises life throws at you.

Safe Financial Service

Overdraft protection is a safe option compared to other expensive financial products like credit cards or payday loans. For instance, high-interest credit cards and payday loans can be damaging to your financial health. Some payday loans can charge as much as 600% in interest, depending on the state you live in.

Since the average interest rate on a credit card balance in 2021 was 14.60%, overdraft protection can be a less costly safeguard. It will help you to avoid late payment charges on your bills, declined transactions, and any embarrassment you might feel as a result.

Avoid Costly NSF Fees

NSF fees can hurt you in more ways than just an additional charge on your account. If you incur too many NSF fees, your financial institution may close your account. Negative information on your account will impact your standing and hurt your ability to open an account in the future—even at other financial institutions!

Not to mention, you still have to pay back your negative balance when your transaction is declined. With overdraft protection, you have the security of knowing the shortfall will be covered until you make another deposit into your account.

3 Things to Remember With Overdraft Protection

If you choose to opt in to overdraft protection, remember to do these three things to set yourself up for financial success:

  1. Develop healthy spending habits
  2. Shop financial institutions and read the fine print
  3. Reevaluate your financial situation regularly

Develop Healthy Spending Habits

While overdraft protection provides benefits to those who may need it, there are also things to be aware of regarding the service. This service, while handy, may encourage unnecessary spending in some people. Knowing that you have $200, $300, or even $1,000 of overdraft protection could lead you to believe that you can live beyond your means!

However, this mindset can get expensive fast and be difficult to recover from. Not only are you potentially paying additional overdraft protection fees, but you’re also inflating your lifestyle, which could become unmanageable in a short amount of time. Focus on developing healthy spending habits so you never have to use your overdraft protection—it’s just there in case of emergency!

Shop Financial Institutions and Read the Fine Print

You should shop around to find the right financial institution that, in addition to providing you with the best-suited products and services, offers overdraft protection service (if that makes sense for you).

The fees may differ depending on where you choose to bank at. Some institutions may charge as much as $38 for overdraft protection, and some may not charge a fee at all. As you compare financial institutions, make sure to read their account agreements so you fully understand the terms and conditions.

Reevaluate Your Financial Situation Regularly

The more financial knowledge you gain, the easier it is to develop healthy financial habits. If you are constantly finding yourself in overdraft, some financial guidance may be needed.

To avoid or minimize your use of overdraft protection, some financial institutions offer a service that will alert you about low account balances. Ideally, if your account balance reaches a certain minimum, you’ll receive an alert letting you know not to make any more transactions until you deposit more into your account.

As your spending habits improve, remember to reevaluate your use of overdraft protection and take note of the progress you make.

Should I Use Overdraft Protection?

Deciding whether or not to opt in to overdraft protection is a personal choice. Overdraft protection isn’t for everyone and shouldn’t be seen as a way to live outside your means. But overdraft protection can be useful to some people, even if simply for peace of mind.

To help you decide if overdraft protection is right for you, ask yourself the following questions:

On average, do I live below my means each month?On average, do I have sufficient funds to purchase most things I need or want?Is my account balance consistently low or overdrawn?

The answers to those questions can help you decide if overdraft protection is for you or not. Overdraft protection is optional; you can add or remove overdraft protection from your account at any time.

Learn More About Overdraft Protection at Lafayette Federal

At Lafayette Federal Credit Union, we offer many tools and resources to support the financial wellbeing of our members. We work with our members to provide the financial assistance they need to succeed—including protection from accidental overdrafts.

Not a Lafayette Federal member yet? You can become a member by completing an online membership application.