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Overdraft occurs when you withdraw more money from your chequing account than is available. If your financial institution approves you for an overdraft account, it will cover any further debit purchases, withdrawals, cheques and pre-authorized payments when your balance reaches zero, up to a predetermined limit. Basically, overdraft is a type of short-term credit that allows you to keep spending money even if there aren’t sufficient funds in your account. For example, if you have only $100 in your account but $500 in overdraft protection, a $200 cheque will still be honoured. If you don’t have overdraft set up for your account, the cheque will bounce and you’ll be charged an NSF fee.
As with any loan, banks don’t extend this credit to you for free. Overdraft protection comes in several different forms, and fees vary widely based on the financial institution and the type of plan you choose.
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Generally, overdraft protection isn’t automatic—you have to request it, your bank has to approve you, and you must agree to its terms and fees. How much protection your financial institution will extend depends on a few different factors: how long you’ve had an account with that institution, your credit history, and even how much money you have in your account. You could also be approved for overdraft protection only on certain types of transactions, such as cheque withdrawals and automatic payments, but not others. If you abuse it by using it excessively, your bank can revoke your overdraft coverage.
Generally speaking, there are three different types of overdraft: protection that allows your account to go negative up to a certain limit, protection that draws funds from linked credit card or different chequing/savings account, or protection that draws funds from a separate line of credit. Each type will have different terms and conditions tailored to the individual.
Basic overdraft protection
Your account can go into the negative, up to a predetermined limit. Some banks may charge a flat monthly fee for each month the account is overdrawn, a daily fee regardless of how many transactions were made, a fee for each transaction, or some combination of the three.
If you make several transactions after your account balance hits zero, you could be hit with multiple overdraft charges in one day. For example, if you make three transactions at $5 each on an overdrawn account and your bank charges $25 per item, you’ll pay $75 in fees on a $15 transaction. Some banks cap the number of per-item charges at a certain number per day.
On top of that, banks may levy interest on the amount overdrawn, though the rate is often lower than many credit cards. Some banks don’t charge overdraft fees on small transactions or if your account is overdrawn by a minimal amount, usually under $5-$10.
Let’s look at an example of the fees you might be charged if your account went into overdraft. Let’s say you have a starting balance of $100, and a $200 bill payment is withdrawn from your account. If your overdraft fee is $5 per day plus 19% interest, you would be charged as follows:
|March 1||Bill payment||-$200||-$100|
|March 1||Overdraft fee||-$5||-$105|
|March 2||Overdraft fee||-$5||-$110|
|March 3||Overdraft fee||-$5||-$115|
|March 31||Overdraft interest||-$0.17||$84.83|
As you can see, you’re charged an individual overdraft fee for each day the account has a negative balance. At the end of the month, you’re also charged interest on the overdraft amount. In this example, the total cost of using a $100 overdraft for three days would be $15.17.
Overdraft line of credit
Overdraft protection can also be set up as a separate line of credit, kind of like a reserve pool you can tap into in an emergency. Like a credit card, you pay interest on the amount you borrow until it is repaid. An overdraft line of credit can be less expensive than traditional overdraft protection, but only if it’s used once or twice a month for small amounts. You might be charged a fee for each time you dip into it, so the more you use it, the more it’ll cost you.
Linked transfer account
Another option that won’t cost you overdraft charges is to link your account to a secondary chequing/savings account or a credit card. In the event your balance reaches zero, your account will automatically draw funds from the secondary account or credit card to cover the transaction. If you link it to your credit card, your regular credit card interest rate would apply to the amount borrowed.
If you have overdraft protection, your bank will cover cheques that would normally bounce. Rather than reject the payment and charge you an NSF fee, the bank will cover the transaction and charge you an overdraft fee. Whereas NSF fees can run as high as $45 per bounced cheque, if you have overdraft protection your bank will charge you either your daily or per-item fee, usually around $5, plus the applicable overdraft interest. NSF cheques can also hurt your credit score, so overdraft protection can be a useful shield against unwanted headaches.
While overdraft protection is useful, it’s meant to be used sparingly and in emergencies. If you’re regularly overdrawing your account and not paying the money back, your bank can cancel your overdraft privileges. Better yet, if you never want your account to have a negative balance, you can decline overdraft protection entirely. Before signing up for overdraft protection, it’s very important to read the fine print to understand what exactly the conditions are and how fees are applied.