What is Overdraft Protection?
(Part 1 of 3)
One of the least understood banking products of the 21st century has got to be Overdraft Protection. Some customers really like it, but as a banker, I can assure you that banks like the fees more. In this post I'll review the following:
- What is overdraft protection?
- What fees are involved in overdraft protection?
- Types of Overdraft Protection
- Overdraft protection laws that help protect you.
What is Overdraft Protection?
In order to understand overdraft protection, you first need to understand overdraft fees and how they are caused. I have a blog post titled "What is an Overdraft", so please read that post first if you're not sure. Once you understand what an overdraft is and how it's caused, you can understand overdraft protection.
Overdraft protection is actually a few different things.
A formal overdraft protection “program” what allows overdrafts and charges overdraft fees. This is described in this post.
Overdraft protection from another account. .
Overdraft protection from a line of credit.
I explain an overdraft protection program in part 1 (this post) of “What is Overdraft Protection?”. Part 2 of 3 talks about overdraft protection from another account. Part three explains overdraft protection from a line of credit. Please read all three parts to understand all your options, it will save you money on overdraft fees.
Overdraft Protection Programs
First, let's take a short trip back in time and remember how overdrafts were handled before overdraft programs even existed. Before – if your account had an overdraft – it was a BIG mystery if the bank would pay the item or send it back nonsufficient funds (NSF). There were always overdraft fees, but an overdraft was discouraged by banks and accounts were often closed because of them. I remember customers calling me because they were all concerned one overdraft would give them bad credit and get them kicked out of the bank!
An overdraft protection "program" takes the mystery out of whether the bank will pay an overdraft item for you. The bank will decide ahead of time how much they will allow your account go into overdraft, usually $500, if you have have direct deposit into your account. What's more important, is they send every qualifying customer a nice letter telling them they can now overdraft their account up to $500 and the bank considers it OK.
Wait! That sounds like a credit line! Technically no, because the banks worded the letters so they didn’t have to pay an overdraft, it is just a courtesy and could be withdrawn at anytime. There isn't interest for a loan, but an overdraft fee. For the most part though, customers thought and depended on overdraft protection programs as a line of credit.
The Debit Card Conspiracy
A big change with overdraft programs is how banks made a system change to allow debit cards to overdraft an account too, plus charge the overdraft fee when it did! Now this is huge, because half of all new overdraft fees came from debit card transactions!
After sending customers the qualifying letters, all those customers living paycheck to paycheck used the extra $500 all the time! Overdraft fee income more than tripled in most banks. Soon it was an industry standard.
Many banks were abusive in making the programs mandatory and stacked fees on fees. It was taking advantage of customers and criminal in some cases. Banks deserved all the bad press!
The government had to step in and make some consumer protection laws, which really limits how banks can run overdraft programs today. Some where changes to Regulation E and some in the Dodd-Frank Act under the Unfair & Deceptive Acts and Practices rules.
How Do Overdraft Programs Work Today?
Banks still have the basic concept of overdraft programs today. They allow you to overdraft up to a certain amount and will charge you an overdraft fee for every transaction. Only now there are some consumer protection laws and best practices banks are responsible to use in their programs..
You must opt into allowing your debit card to be used in the program.
There are multiple notification requirements they have to send you.
Charging for small overdrafts of $10 or less is criticized
Limiting daily fees is strongly encouraged
Ordering charges to result in maximum fees (large to small) is criticized
You must be allowed to opt out of debit card inclusion, even after opting in
The best thing is they can’t treat everyone the same. This is rooted in something called "safety and soundness" because not every customer poses the same risk level of paying back an overdraft. This means different customers have different limits, which adds some of the mystery back into whether the bank will pay an overdraft or not. I think that’s a very good thing.
In review, this post detailed the type of Overdraft Protection Program in which a bank will allow you to overdraft an account because they think you will pay it back. If qualified, they send you a letter basically telling you it's now OK to overdraft your account and they'll let you – and gladly charge you the same big overdraft fee for each ovedraft! After the practice became widespread and abusive, the government stepped in and placed some rules that would limit fees and allowed you to have more control over your debit card inclusion in any overdaft protection program. To understand all your ovedraft protection alternatives and save money, please consider reading Part 2 of What is Overdraft Protection, which details Overdraft Sweep, and Part 3 of What is Overdraft Protection, which details an Overdraft Protection Credit Line.
If you have any questions or comments on this post, email me using the Contact page.
I’m Banker X, and I’m on your side.
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