Overdraft Protection

Overdraft protection is the name banks and credit unions give to arrangements that fund a transaction when the available balance will not cover it, so the payment goes through instead of being returned. The phrase is a product name, not a term of art, and it is worth knowing that federal regulation uses it in the opposite direction from the way the marketing does.

Regulation E defines an overdraft service at 12 CFR 1005.17(a) as a service under which an institution charges a fee for paying a transaction, "including a check or other item", when the consumer has insufficient or unavailable funds. It then excludes four things from that definition: a line of credit subject to Regulation Z, "including transfers from a credit card account, home equity line of credit, or overdraft line of credit"; "a service that transfers funds from another account held individually or jointly by a consumer, such as a savings account"; a line of credit or other transaction exempt from Regulation Z under 12 CFR 1026.3(d), which covers credit extended in a securities or commodities account by a registered broker-dealer; and certain hybrid prepaid-credit-card features.

Read those exclusions against the sales literature and the useful fact falls out. The first two are precisely what most institutions call overdraft protection. So the thing being sold under that name is, by regulation, specifically not the thing the overdraft rules govern, and the rules that do govern it are somewhere else.

There are three ways an account can go negative, and they are three different legal events. Distinguishing them is the whole job of this page, because the cost and the rights attached to each are different.

The linked-account transfer moves money you already have, usually from a savings or money market account at the same institution, and sometimes from a second checking account. Nothing is borrowed, so no interest accrues. What the institution charges instead is commonly a flat fee per transfer, and the amount varies enough between institutions to be worth reading in the fee schedule rather than assumed. Some charge nothing. Two mechanical details decide whether this works in practice: whether transfers are made in the exact shortfall or in fixed increments, and whether the linked account has to hold the money at the moment the item posts, which it often will not on a day when several items arrive together.

The overdraft line of credit is genuine credit. Because it is subject to Regulation Z, the balance accrues interest at a stated annual percentage rate from the day it is advanced until it is repaid, and it brings the Regulation Z apparatus with it: periodic statements, a disclosed rate, and the written billing-error procedure. It also has to be applied for and approved, so it is not available to everyone and the decision usually involves a credit check. Some institutions charge an advance fee per draw on top of interest, which changes the arithmetic considerably on a small shortfall.

The discretionary service is the one the opt-in rules reach, and it is the one that produces the flat per-item fee people mean when they complain about overdrafts. That mechanism, the narrow scope of the federal permission requirement, and how it differs from a returned item are covered on the overdraft page and are not repeated here.

The comparison worth internalizing is not fee against fee, but cost against amount advanced. A flat charge is a small number in isolation and an enormous one relative to a shortfall of a few dozen dollars. Interest at an ordinary consumer rate on the same shortfall for a few days is measured in cents. That is why the ranking between these arrangements almost never turns on the headline rate.

One quirk of a joint account carries over into every version. Regulation E treats the affirmative consent of any one holder of a jointly held account as consent for the account, and a revocation by any one holder as revocation for the account, so one person can switch the discretionary coverage on or off for both. Where the arrangement is instead a linked transfer or a credit line, the account agreement rather than Regulation E controls, and the two holders' positions are set by that contract.

What none of these arrangements does is create money. A linked transfer works only while the linked account has a balance; a credit line works only up to its limit and leaves a debt behind; the discretionary service is not a commitment, and an institution can decline to pay an item whether or not it has paid one before. Each of them buys time and avoids a returned payment. None of them addresses a month that does not balance.

You choose an arrangement in advance, usually when the account is opened or through the bank's app, and it sits dormant until an item arrives that the available balance cannot cover. At that point the institution follows whatever you set up: it transfers from the linked account, advances on the credit line, pays the item and charges a fee, or returns the item unpaid. Institutions generally apply these in a stated order, so it is worth knowing which one your account reaches for first.

A hypothetical example comparing the three, using assumed fees and a rate. Institutions set and disclose their own, and the point of the arithmetic is the ratio rather than the amounts.

Dario's account is $40 short when an item posts.

Under the discretionary service, the bank pays the item and charges an assumed $34 overdraft fee. The charge is 85% of the amount advanced ($34 divided by $40).

Under a linked savings transfer, the bank moves $40 from his savings account and charges an assumed $10 transfer fee. Nothing is borrowed, so nothing accrues, and the cost is 25% of the amount moved ($10 divided by $40).

Under an overdraft line of credit at an assumed 18% annual rate, repaid when his pay arrives 10 days later, the interest is about $0.20 ($40 times 0.18 times 10 divided by 365). If his institution also charges an assumed $10 advance fee, the total is $10.20, and if it does not, the total is twenty cents.

Three arrangements, one shortfall, and a cost that ranges from about twenty cents to thirty-four dollars. Notice what actually drives the answer: the charge that scales with time and amount is the cheap one on a small, quickly repaid shortfall, while the flat charges are expensive precisely because the shortfall is small. Reverse the facts, and a credit line carried for months stops looking cheap.

Pros

• The payment goes through, which avoids a returned-item charge from the bank and a returned-payment or late fee from whoever was expecting the money.
• The linked-account version moves money you already own, so nothing is borrowed and nothing accrues.
• The line-of-credit version is usually far cheaper than a flat fee on a small shortfall repaid quickly, and it carries Regulation Z rights the other versions do not.
• Both are set up once and then work without any action at the moment they are needed, which is the moment nobody is paying attention.

Cons

• The phrase is a product name with no fixed meaning, so two institutions can sell mechanically different things under it.
• A flat transfer fee on a small shortfall is still a large percentage of the amount moved, and it can apply to each transfer on a day when several items post.
• A linked transfer fails silently when the linked account is empty, which is exactly when a household is most likely to overdraw.
• A credit line has to be applied for, is not available to everyone, and leaves a balance that keeps accruing until it is repaid.
• None of these arrangements is a commitment by the institution to pay a particular item.
• Because the arrangements sit outside Regulation E's overdraft-service definition, the opt-in protections people associate with overdrafts do not attach to them.