What is a Bank Account Overdraft?
A bank account overdraft happens when an individual’s bank account balance goes down to below zero, resulting in a negative balance. It usually happens when there are no more funds in the account in question, but an outstanding transaction is processed through the account, leading to the account holder incurring a debt.
A debt is incurred because, with an overdraft, the bank effectively automatically lends the amount necessary to process the transaction to the account holder, an amount that needs to be returned, along with possible fees. Though it seems helpful to the account holder, costs can spiral out of control if overdrafts are not handled promptly and properly.
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 wrote a check for the purchase. However, when the merchant deposited the check in the bank, Mary’s account only contained $1,500, which means that she is $500 short of what is due for the check.
Two outcomes are possible – either the merchant’s bank will pay him the full amount, or they will let the check “bounce” to Mary’s bank and stamp it with “NSF” (non-sufficient funds). In case the first outcome unfolds, Mary will be charged for the $500 overdraft.
Types of Bank Account Overdrafts
The two types of bank account overdrafts are authorized and unauthorized overdrafts.
1. Authorized bank overdraft
With an authorized overdraft, the arrangement is made well in advance between the account holder and their bank. Both parties agree to a borrowing limit that can be used on all normal payment methods. Of course, the arrangement comes with a service fee that varies from bank to bank.
Usually, the fee is charged daily, weekly, or monthly, plus interest, which can be as high as a 15% to 20% annual percentage rate. Considering the sometimes very high fees, an overdraft arrangement can be very expensive, especially if the borrowed amount is very small. That is why account holders should be very careful to avoid overdrafts, even authorized ones.
2. Unauthorized bank overdraft
As the term implies, this means that the overdraft has 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, if the account holder has gone beyond the agreed overdraft amount.
Unauthorized bank account overdrafts incur higher fees, which makes them more expensive.
Advantages of Bank Account Overdrafts
Bank account overdrafts are not always a bad practice. They can carry 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 a total of $6,000 need to be paid. In such a case, the overdraft can be used to settle the outstanding check balances. The account funds will be restored as receivables are paid.
2. Prevents bouncing checks
Bouncing checks harms one’s credit standing. With a bank account overdraft, bouncing checks is prevented.
3. Enables on-time payments
In addition to the previous point, no payments are late due to insufficient funds, because the overdraft shoulders the deficit. This protects the account holder’s credit score and also helps them to avoid having to pay late fees to suppliers.
4. Saves time and paper
Compared to standard long term loans, bank account overdrafts are relatively easy to handle, 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 to avoid overdrafts and the accompanying fees:
1. Monitor account balance regularly
This sounds very simple, but it is often forgotten by many people. It is by constant checking that the account holder is able to determine how much he or she can spend. This can be easily done with the technology available today, such as a bank’s mobile app.
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 a temporary increased overdraft limit. If they have usually managed their account in a responsible manner, the bank will usually grant such a request.
3. Read bank letters
Many are guilty of disregarding bank letters, thinking they are just routine communication. However, they sometimes contain important information about your bank account, including notices of an overdraft.
4. Transfer accounts to another bank
Some banks are bank account overdraft-friendly and don’t charge fees or interest. They are just thankful to get clients to open and maintain an account with them. If you are prone to overdraft situations, then it may serve you well to seek out such a bank for your accounts.
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 CFI resources will be helpful: