Bank Account Overdraft

What is a Bank Account Overdraft?

A bank account overdraft is a debt instrument financial institutions use to provide additional financial services to clients by processing their transactions on their behalf when they deplete their available bank account balances. It is a short-term debt when you need additional money. 

An overdraft allows an account holder to withdraw money more than what they had in their bank account granted by the bank, which is subject to overdraft fees and interest rates set by the bank. You could say an overdraft is excessively “overdrawn” from the account.

“Well, isn't that a great thing to have?” Not really. There are pros and cons to every man-made policy. A normal person is not going to receive such services unless the person has a good track record of repaying the due amount to which a bank can trust, in other words, a credit score. 

If it is too good to be true, then it probably is, as there are additional strings attached to it. Remember, financial institutions are there to make money. An overdraft is a form of credit that is useful when used strategically, and if misused, it can spiral you down into excessive debt. 

Therefore, you should know when to take advantage of it at the right time. It is better to be prepared than to be sorry. Let's learn more about overdrafts so that you can make better-informed financial decisions.

Understanding Bank Account Overdraft

As mentioned before, a bank account overdraft is a privilege granted by financial institutions to withdraw more money when the bank balance of the account holder reaches zero. These credit services are useful when the payment made by the account holder gets rejected or bounced. 

An overdraft is an additional credit service the bank provides, similar to a loan but short-term in duration. This service allows borrowers to obtain a short-term loan for a need or want with an attached overdraft fee and an interest rate. 

Not every account holder can obtain such services as the banks and financial institutions only provide such services to those individuals whose credit score is trustworthy, i.e., those who have a history of repaying the lent amount at the right time with the right amount. 

Therefore, building trust with the banks and financial institutions to avail such financial services is crucial for financial survival and growth. 

Since the overdraft is considered to be a short-term loan, it does possess obligatory interest rates but not as much as interest rates implied on credit cards. Hence, it is ideal for emergencies. 

As mentioned before, banks and other financial providers do possess the ability to set interest rates as well as overdraft fees. However, they do not possess the ability to change the event of the transaction itself to charge the customer more than it is supposed to.

Now, banks and other financial providers can provide bank account overdraft services using their own available funds after considering whether you are fit for it. Utilizing overdraft in this approach does not affect your credit score. 

If your credit score is a deciding factor, then linking the bank account overdraft with your credit card allows you to increase debt to a level that affects your credit score. But it is more risky, as banks are most welcome to transfer your case to a collection agency if you default. 

Bank Account Overdraft Example

Let’s use a simple, practical illustration of how an overdraft works in a real-life situation:

Rosie is a real fitness enthusiast and an enthusiast like her dreams of a home gym. And that is exactly what Rosie wants: to buy the latest gym equipment for her house. The heavy equipment will cost her $1,300. She deemed it to be a bright investment as it takes up less house space. 

Rosie has $800 in her bank account. Since she gets her paycheck on the 5th of every month, she decided to write a check for $1,300 on the day she receives it. Unfortunately for her, her next month’s paycheck was postponed to two days after her usual payday.

Now, the fitness equipment company to whom she wrote the check can take two approaches:

1. Take the quickest route: let the company’s bank bounce the payment with the attached NSF (Non-Sufficient Fund) stamp and NSF charge to Rosie’s bank. Or
2. Accept the payment as the bank covers Rosie if the company’s bank allows Rosie to redeem bank account overdraft services based on her credit score. If the bank allows, then Rosie incurs a $500 overdraft along with additional overdraft fees and interest rates.  

Types of Bank Account Overdrafts

Financial providers who facilitate overdrafts provide the overdraft to credible borrowers in two ways due to various situations and circumstances. This allows protection to the financial providers depending on whom they facilitate the financial services. The types of overdrafts are: 

1. Authorized Bank Account Overdraft 

An authorized bank overdraft is a contractual agreement between the borrower and the financial provider, i.e., the bank, in facilitating the overdraft services by restricting account holders’ borrowing limit in any form of payment. 

Authorized overdrafts are charged overdraft fees, which are set by the banks, either on a daily, weekly, or monthly basis, again depending on the banks, and the overdraft also incurs interest rates, which can be as high as 15% to 20%, depending on the banks. 

2. Unauthorized Bank Account Overdraft 

An unauthorized bank overdraft, given the name’s suggestion, is a non-contractual agreement between the account holder and the financial provider, i.e., the bank, in facilitating the overdraft services to the account holder. 

Unauthorized overdrafts typically occur when the account holder has spent more than their available bank balance and has exceeded overdraft funds with or without any prior agreement with the financial provider. Due to the risky nature of unauthorized overdrafts, it incurs high fees.

Advantages of Bank Account Overdrafts

Bank account overdrafts, like any financial service provided by financial providers, come with advantages and disadvantages. Knowing both the advantages and disadvantages is crucial when approaching such services, as no financial providers run on charity. 

The points below explore some of the advantages of making overdraft services available to individuals and companies alike. First, let us explore some of the advantages bank account overdrafts have to offer.

1. Cash security: An individual may not always have cash all the time. In reality, expenses that are incurred don't revolve around when the income arrives, making it difficult to pay expenses incurred before payday. Therefore, a bank account overdraft can cover expenses when there is no cash at hand. 
2. Preventing checks from getting bounced: This complements the previous point, as when an individual or a business doesn't have cash at hand or in the bank, the checks that are written to cover the expenses will get bounced as there are no funds in the bank account. Therefore, a bank account overdraft can cover those expenses. 
3. Enable payments on time: Again, this point complements the previous point, as when individuals or businesses make payments on time even when they don't have funds (overdraft), it builds strong relations with others, especially the bank when the overdrafts are paid later on building in the credit score. 
4. Convenience: Convenience is the prime factor for a bank account overdraft. An overdraft is meant to bring convenience for the borrower to avoid financial burdens (if done right). An account holder can redeem an overdraft anytime, anywhere, as long as the bank doesn't withdraw from the agreement.  
5. Saves time: Besides the previous point, a bank account overdraft is crafted conveniently for the account holders. An overdraft is much more efficient in time and effort as it requires minimal paperwork and easy handling.

Disadvantages of Bank Account Overdrafts

Since we have explored some of the advantages that prove useful for individuals and businesses, it is best to know some of the disadvantages of approaching such services. Below, we explore some disadvantages of using bank account overdraft services.

1. High Overdraft Fees: As mentioned before, always expect an overdraft charge implied when approaching a bank account overdraft service. Both authorized and unauthorized, especially unauthorized, incur heavy fees due to their risky nature. 
2. High-Interest Rates: Again, the same goes for interest rates. Interest rates implied on overdraft services can reach up to 15-20 % for an authorized bank account overdraft. It's natural to expect even more for unauthorized ones. The rates are drastic compared to other sources, preventing people from borrowing.
3. Restriction Limit: Any individual who approaches to obtain an overdraft service from a financial provider and enters into a contractual agreement, i.e., authorized overdraft, is restricted on the limit the individual can borrow. This can be troublesome when an individual requires additional funding. 
4. Risk of Seizure: Since an overdraft is deemed to be a form of a short-term loan, it is backed by possessing the characteristics of a loan, especially the collateral, a safeguard measure for the financial providers. In case of a default, an individual risks their asset for short-term funding.
5. Over Convenience: Convenience is the prime motive for a bank account overdraft. But there is a high chance that this convenience can backfire multiple folds. Companies that utilize overdraft services regularly can become lethargic in collecting debts from debtors, all due to over-convenience. 
6. Financial Checkmate: The bank directs the financial services, especially the bank account overdraft. The bank has the final say as it sets the fees, charges, interest rates, payment terms, and the ability to reduce or cancel the overdraft without notice. It's one of the strategies to trap people in debt.

How to Prevent Bank Account Overdrafts

As you have seen from the above advantages and disadvantages, approaching an overdraft should be taken with appropriate considerations, verifying whether the risk is worth the circumstances, as a wrong move can heavily cost the borrower. 

It is better to have precautions to avoid unwanted situations of redeeming overdrafts when not needed. Below are some of the practical precautions every individual having an overdraft facility should observe: 

1. Regular bank account monitoring 

This is the most common one out there, an essential element in personal finance, but people tend to forget about it. Monitoring your accounts lets the individual know where to draw the line in spending, resulting in knowing your budget and avoiding careless spending.  

2. Read letters from the bank 

We know it is hard to read those letters. It mostly contains information the bank wants to communicate with you, which you may pass off as “nothing new or routine” from the bank. But many are guilty of this, as these “routine” letters contain crucial information such as overdraft notices. 

3. Communicate with the bank 

Now, if the individual is an avid user of overdraft services, this can be difficult to control. Fortunately for the cases of authorized overdrafts, such individuals can approach the bank requesting a decrease in the allowed borrowing limit. 

Whether the bank will allow such requests is up to them. But they are most likely to allow it as long as you prove credible, someone who pays on time. As mentioned before, building credit scores builds stronger relationships with financial providers.  

4. Link to other income sources 

Another way to prevent an unwanted debt trap is to link your checking account to any other source of finance, such as a savings account or checking account. This creates a safeguard to prevent access to an overdraft by withdrawing funds from the linked source of finance.

5. Transfer funds

In finance, not all financial providers are money-hungry bankers, charging abnormal fees and heavy interest rates as a cherry on top. But some provide financial services, including overdraft, free of charge or no interest at all.

If such financial providers exist in your locality or near you, it is a good place to transfer your funds to redeem such services, as these services lower your financial burdens and help avoid unwanted debt situations.  

Note that even such institutions may have a catch with them, like being unable to increase the limit as they are not making heavy money to provide heavy financial services. Either way, these institutions are happy to provide such services as long as you maintain them. 

Researched and authored by Muhammed Ishfaque Ishaque | LinkedIn 

Reviewed and edited by Mohammad Sharjeel Khan | Linkedin

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