An overdraft can occur any time you attempt to spend money that isn't in your bank account. Investopedia defines an overdraft as an extension of credit from a lending institution when an account reaches zero, like writing checks or using your debit card when there are insufficient funds to cover the transaction. Depending on how your account is set up, the bank may temporarily fund the payment on your behalf.
Advantages of Overdrafts
While it's never a good idea to spend more money than you have in the bank, there are a few advantages of creating an overdraft, which you can only do if your bank account has overdraft protection.
- Avoiding returned checks: If you write a check for more than the balance in your checking account, it will clear the bank anyway if you have overdraft protection. That means that the party to whom you wrote the check will still get paid. You won't have to deal with a returned check charge or the hassle or embarrassment associated with writing a bad check. Plus, the cost associated with an overdraft fee may be less than the cost of failing to get a large bill (such as your mortgage payment) paid on time.
- Completing purchase transactions: If you find yourself in a situation where you have to make a purchase and you don't have the money to cover it and you don't have access to a credit card, creating an overdraft using a check or your debit card can allow you to buy what it is that you need. While this isn't an ideal option, if you find yourself in an emergency situation like needing to purchase medicine or running out of fuel, it can be better than the alternatives.
Disadvantages of Overdrafts
While there are a few situations where an overdraft can help you out in a pinch, it is best to avoid them. Key disadvantages include:
- Incurring overdraft fees: The bank doesn't create an overdraft for you for free. There is a fee any time you spend more money than what is in your checking account. Depending on the account you have, you could get charged anywhere from $5 to $45 per overdraft, according to the Chicago Tribune. The majority of fees are not at the lower end of the spectrum. According to NerdWallet, as of 2017 the median overdraft charge was $37.
- Damaging standing with the bank: It's important to have a good relationship with your financial institution for a variety of reasons, but getting in the habit of creating overdrafts too often could stand in the way. According to Credit Karma, if you have excessive overdrafts or are slow to restore your account to a positive balance, this could "cause your checking account to be canceled or applications to open new checking accounts to be rejected."
- Damaging credit score: According to Experian, "Checking account overdrafts do not directly affect your credit scores." However, it is up to you to correct any negative balances in a timely manner. If you don't pay your overdraft fees or fail to deposit sufficient funds back into your account, the bank may end up sending your account through a collections process. When this occurs, as Experian points out, "it could appear in your credit report and hurt your credit." You could find yourself with a cancelled checking account in a situation where another bank won't approve you for a new one.
Best Practice
While there are some situations where an overdraft may be advantageous, it is generally best to avoid overdrafts entirely. Do this by creating a budget, setting up an emergency fund, keeping an extra cash cushion in your account, managing your checkbook and checking your balance before making a purchase or writing a check. If you want to avoid overdraft fees and other negative consequences, talk to your bank about setting up a less expensive option.
For example, if you have a savings account, you could link your checking account to it. Or, your bank may offer a credit card product that you can link to your checking account such that any account overages would simply be charged to the card. You may even want to opt out of overdraft protection entirely so that you are not able to process any transactions when you don't have enough money in the account. With this option, you run the risk of bouncing a check or having your card declined, but you alleviate other potential risks.
