Overdraft Fees

How Does An Overdraft Work?

How Does An Overdraft Work?

As a banker, I get this question quite a bit.  When you think about it, don’t you find it quite amazing none of those “valuable” high school courses didn’t have a day or so to talk about bank account overdrafts?  Didn’t someone think it may be useful to learn how to avoid overdraft  fees and save thousands of dollars over our lifetime?  I guess learning geometry – which I never use- was more important! Knowing how overdrafts work will definitely Save Money.


How Overdrafts Work

Firstly, when someone says “overdraft” I think they are really asking what causes an overdraft related fee.  Overdraft related fees are pretty steep!  Some banks charge over $35!  So understanding how overdraft fees work is very important.  To understand how an overdraft works, you need to know the two broad categories of overdraft fees – an overdraft fee and a non-sufficent funds (NSF) fee.


An Overdraft

This is when your account goes negative, which means you owe the bank money.  An overdraft usually occurs when the bank pays something for you, or has to pay something for you, which brings your account negative. A bank may bank something for you because they have given you some kind of an overdraft courtesy program because they think you will pay it back,  An overdraft courtesy program is a whole other blog topic, so read that one too.  A bank may have to pay something for you because of something called “force-post” transactions. That’s a whole other topic and post, but read about that one too because you can usually wiggle out of those overdraft fees.


Here’s an example of how an overdraft works when the bank pays your items and then you'll owe the bank the money.  Paying customer ovedrafts can be part of an ovedrraft program.  If you don't know what an overdraft program is, check out my Overdraft Program post too.   Let's assume you start the day with $50 in your checking account.  Your car insurance company sends through a $150 automatic payment,  which you authorized monthly.  When this payment is presented to the bank, it creates a potential overdraft of -$100 ($50 – $150) and goes into an overdraft file.. Large banks process overdrafts by computer that has preset limits of how much to allow a customer to go into overdraft.  Smaller banks actually have someone looking at the overdraft file, who makes a decision to pay or return the payment according to bank policy.  If the bank decides to pay the $150 overdraft payment, your account will go into the negative by the $100 and will most likely get socked with an overdraft fee.  In our example, let’s say the bank’s overdraft fee is $25.  Now the bank will subtract the overdraft fee of $25 from your negative account balance of $100, making your total overdraft -$125.  ($50-$150-$25).  Ouch!  


Things can really go sideways if you have more than one payment coming into your account that day.  Let’s say your gym membership for $20 and your phone bill for $50 also get presented to the bank and they pay those too.  Now you owe the additional $70 ($20+$50), plus you’ll get two more overdraft fees of $25 each, so you go in deeper another $120 ($20+$50+$25+$25).  So your total checking account overdraft is -$245 (-$125 + -$120)!  Ouch! Ouch! Ouch!


Beginning Balance Debit Credit $50.00
Auto Insurance ($150.00)   ($100.00)
Gym Membership ($20.00)   ($120.00)
Phone Bill ($50.00)   ($170.00)
Overdraft Fee ($25.00)   ($195.00)
Overdraft Fee ($25.00)   ($220.00)
Overdraft Fee ($25.00)   ($245.00)


How Non-Sufficient Funds Work

In addition to how overdrafts work, you should know how their twin brother Non-sufficient Funds (NSFs) work too.  In the case of an NSF and using the above example,  the bank could make the decision to NOT pay all those payments to your auto insurance, gym membership, and phone provider by sending them all back NSF.   This means your account won’t be subtracted for the $150, $20, and $50 – but the bank will usually still charge you three NSF fees.  Most banks make their overdraft fee and NSF fee the same, but some are different. What’s worse, all your companies will usually wack you with a return payment fee too!  What’s the worst is those companies will usually try to deduct the payments in a couple more days and if there isn’t enough money in your account by then  – the fees start all over again!  


Save Money on Overdraft Fees

As a banker, I find the people that get the most overdraft fees are usually the people who can least afford it.  I’ll have a post on Getting Back Overdraft Fees, but the best way to save money on them is to not get them in the first place.  That means picking the right checking account to minimize or eliminate overdraft fees.  I see a great trend in banking today that has some banks introducing checking accounts with no overdraft fees.

BankerXI’ll make a post about no overdraft fee checking accounts too, but you can do you own searching on Google. These accounts will usually charge a small monthly fee, but it’s worth it to avoid hundreds in fees!   Thankfully bankers are waking up to the fact that many people need this account option and are doing the right thing. Yes, my bank has one too. Switching to a no overdraft fee checking account can save you thousands on fees, so it’s worth the look.

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