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Jan 08, 2019

Understanding Overdrafts

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With a new year often comes a new perspective on managing money. Following a holiday season filled with gift giving, extra grocery shopping, and charitable donations, maybe you found yourself paying overdraft fees on your accounts. This can be a stressful and embarrassing situation, and in truth, a lot of people aren’t really sure what an overdraft is and how it works. So let’s get some clarification on overdrafts and insight on how to avoid them in the future.

What is an overdraft, anyway? At its basic level, an overdraft means spending money that you don’t have in your account. It happens when the checks, debits, and withdrawals from an account exceed the amount of money that is available.

An overdraft is not the same as putting something on credit. In that instance, you intentionally borrow money from the bank or credit card company for a purchase, knowing you must pay it back. In an overdraft situation, there is no credit or borrowing; there is just an account with a negative balance.

Here is a scenario to illustrate. Imagine you are at home paying bills by sending payment via checks in the mail or perhaps paying online. Meanwhile, maybe your spouse is out buying supplies for a home improvement project. If your bank account has $1,000 in it and you pay $900 worth of bills while your spouse pays $150 with the debit card at the hardware store, you will have spent more than is in the account. If all those debits and checks clear before you deposit more money, you will overdraft.
Also called having non-sufficient funds (NSF) or being overdrawn, overdrafts can lead to some significant problems.

What happens in an overdraft situation? Unless you have some kind of overdraft protection in place (more on that shortly), if you write a check or authorize a debit that your account cannot cover, the financial institution doesn’t pay it. So the payee (the garbage company, for example) doesn’t get their money.
Even once you are able to cover the payment, it is possible that the company will add fines or late fees, costing you even more than the original bill. In addition, the bank or credit union will likely assess a fee for the non-sufficient funds. These added fines, fees, and penalties make a tough situation worse quickly.

Did you know...

In 2017, Americans paid more than $34 billion in overdraft fees.

Depending on your financial institution’s process, the order by which they post credits versus debits or certain dollar amounts could result in a negative balance and increased NSF fees. For example, let’s say you have $100 in your account and you authorize debit charges of $40, $60, and $150, in that order. You may expect that the first two will clear just fine and the third will trigger an overdraft fee which can be around $35.

If they instead processed the last charge first, that would trigger a fee for NSF. Then when the other two are processed, each of those would also result in a charge since the account is now at a negative balance. What you thought might have resulted in a $35 fee has instead become a $105 penalty simply because of process.
Clearly, overdraft situations aren’t ideal. They can escalate an already difficult financial time into a huge problem. It’s important to understand how your financial institution processes transactions and be sure to ask questions if you aren’t sure.

So what Is overdraft protection? To help people avoid these challenges, financial institutions have come up with a system you may opt to use: overdraft protection options.
As its name implies, overdraft protection provides a safety net if you overdraw your account. Choosing this service tells the credit union or bank that, if you have an overdraft in your checking account, they should still allow the transaction to process to help avoid further fees from the merchant. This is often based on the relationship with you have with the institution since it would allow your account to go negative. Many credit unions and banks allow you to pull the amount automatically from a separate account to cover the overage. It may be a savings account, a credit card, or a line of credit. No matter the option, it’s important to know how your account is structured so you understand the financial implications which likely still includes NSF fees and/or loan interest.
These options may save you from having to pay hefty overdraft fees and ensures everyone gets paid what you owe them. Keep in mind that overdraft protection is for unexpected NSF situations. It is illegal to write a check that you know your account cannot cover.
Overdraft protection is not an automatic service. It is illegal for financial institutions to set it up for you without your permission. You must opt-in to receive this service.

Keep in mind.

Although overdraft protection can give you some peace of mind, it should be a rare, occasional need. If you find that you are using it frequently, you may want to examine some of your money habits.

How can I avoid overdrafts? The best thing, of course, is not to overdraw at all. Here are some tips to get you started:

  • Make a detailed budget and stick to it as faithfully as you can. Spend a full month tracking your spending so that you can build an accurate budget, find areas to cut back, and have a clear understanding of where your dollars are going.

  • Record every transaction you make with your checking account, including debit card payments, and be careful with your math. Always keep a current running balance so you know how much you have available. Remember, you can’t rely solely on the balance that shows up when you check your account online. You must subtract any unposted/pending checks or debits to have an accurate balance.

  • Multiple people accessing one account? Talk to each other about your spending plans. It is very easy to go into overdraft if you have multiple people using the same account. Make sure anyone using the account has a current balance.

  • Check your account(s) regularly with digital banking portals. These platforms make it easy to see which transactions have posted and which are pending. But again, be sure to take into account any checks or debits you have authorized that aren’t yet showing online.

  • Consider switching to cash-only for spending at least until you can get a handle on your budget. There are many different organizational envelope systems to help with this type of planning.

Many people experience the frustration of overdrafts at some point in their adult lives; it happens but it doesn’t have to continue happening. Educating yourself is a great place to start.

Contents of this blog article are intended to provide you with a general understanding of the subject matter. However, it is not intended to provide legal, accounting, or other professional advice and should not be relied on as such. Information may have changed since the publication date.

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