Become a Financial Modeling & Valuation Analyst (FMVA)®. Enroll today to advance your career!

Bank Account Overdraft

A situation wherein an individual’s bank account balance goes down to below zero, but the transaction still went through

What is a Bank Account Overdraft?

A bank account overdraft happens when an individual’s bank account balance goes down to below zero. It usually happens when there are no more funds in the account in question, but the transaction still went through, leading to debt.


Bank Account Overdraft


Yes, a debt is incurred because, in overdrafts, it is the bank that automatically lends the amount in the transaction to the account holder which, of course, still needs to be returned, with fees. Though it seems helpful, costs can spiral out of control if overdrafts are not managed.


Example of a Bank Account Overdraft

Consider the following scenario. Let’s say Mary went to a retail outlet and purchased cosmetics amounting to $2,000 and issued a check with the same amount. However, when the merchant deposited the check in the bank, he finds out that Mary’s account only contained $1,500, which means that she is $500 short of her dues.

Two outcomes are possible – either the merchant’s bank will pay him the full amount, or he will let the check “bounce” to Mary’s bank and stamp it with “NSF” or non-sufficient funds. In case the first outcome happens, Mary will be charged for the overdraft.


Types of Bank Account Overdrafts

The two types of bank account overdrafts are authorized and unauthorized overdrafts.


1. Authorized bank overdraft

Because it is authorized, the arrangement is made well in advance between the account holder and his bank. Both parties agree to a borrowing limit that can be used on all normal payment methods. Of course, it comes with a service fee, and the fee varies from bank to bank.

Usually, the fee is charged daily, weekly, or monthly, plus the interest, which can be up to 15% to 20% annual rate. Looking at daily fees, it can be too expensive especially if the borrowed amount is very small; that is why account holders should be careful.


2. Unauthorized bank overdraft

From the name itself, it means that overdrafts have not been agreed upon in advance and the account holder has spent more than his account’s remaining balance. Unauthorized overdrafts can also happen even if there has been a prior agreement, but the account holder has gone beyond the agreed overdraft amount.

Unauthorized bank account overdrafts charge higher fees, which make them more expensive.


Advantages of Bank Account Overdrafts

Bank account overdrafts are not always a bad practice as it also brings advantages, including the following:


1. Perfect for mismatch of cash

When payment dates arrive before all receivables do, overdrafts are very helpful. For example, a business keeps only $5,000 in its bank account and three checks amounting to $6,000 need to be paid; then, the overdraft can be used to settle the outstanding check balances.


2. Prevents bouncing checks

Bouncing checks destroy credit standing. With a bank account overdraft, bouncing checks are prevented.


3. Allows on-time payments

In addition to the previous point, no payments are late due to insufficient funds because the overdraft will shoulder the deficit.


4. Saves time and paper

Compared to standard long-term loans, bank account overdrafts are easy to avail, requiring minimal paperwork.


5. Provides convenience

Overdrafts can be made anytime, as needed, as long as the agreement is not withdrawn by the bank.


How to Prevent Bank Account Overdrafts

Bank account overdrafts can be avoided, especially if the account holder knows that he or she may spend beyond the amount of his or her money in the account. Here are some helpful ways:


1. Monitor account balance regularly

It sounds very simple and common, but it is often forgotten by most people. It is by constant checking that the account holder is able to determine how much he or she can spend. It can now be easily done, considering the technology today, such as by using the bank’s app, setting up a text alert for balance inquiry, or using phone or internet banking.


2. Speak with the bank

If one thinks that the existing authorized overdraft isn’t enough, then, the account holder should go and talk to the bank and request for a temporary increase of limit. Of course, the account holder should pay responsibly.


3. Read bank letters

Many are guilty of disregarding bank letters, thinking these are just routine communication. However, they may contain important information about your bank account overdrafts.


4. Transfer to another bank

Some banks are bank account overdraft-friendly and don’t charge fees and interest. They are just thankful to get clients open an account with them.


Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Bank Line
  • Bridge Loan
  • Debt Covenants
  • Financing Contingency

Financial Analyst Training

Get world-class financial training with CFI’s online certified financial analyst training program!

Gain the confidence you need to move up the ladder in a high powered corporate finance career path.


Learn financial modeling and valuation in Excel the easy way, with step-by-step training.