What is an Overdraft?

Published by Thomas Herold in Banking, Laws & Regulations

'Overdraft' is explained in detail and with examples in the Laws & Regulations edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

An Overdraft refers to the extension of credit where a bank or other lending institution allows for debits to be paid after an account has hit zero dollars. Thanks to these overdrafts, individuals are able to keep drawing down the account value below zero, although there is no money left in it or an insufficient amount to resolve the withdrawal. Another layman’s definition of this term is when the bank permits its clients to borrow a given sum of money.

When individuals possess an account with overdraft facilities, the bank will courtesy cover any checks that will put it into overdraft instead of returning them unpaid (bouncing them back to the check depositor). Naturally the outstanding overdrawn balance will have interest charged on it, as with any loan. Typically such interest rates prove to be far lower than those offered by credit cards though. Sometimes there may be other fees for utilizing the overdraft protection. This would decrease the overdraft protection amount available. Some of these could be per withdrawal or per check insufficient funds assessed fees.

Such overdrafts on money market savings accounts, regular savings accounts, and checking accounts happen when the customers do not keep sufficient funds within this account to cover the incidents such as check and ATM withdrawal transactions. In order for it to equal an overdraft, the bank will have to be willing to process and cover the transaction regardless of the shortfall of funds.

Many banks will pay overdrafts on four kinds of banking transactions. These include recurring transactions of debt cards, checks and related transactions that rely on the account number, online banking transfers and payments, and auto bill payments.

Banks might decide to utilize their own corporate funds in order to pay a client overdraft. They might also have customers link the overdraft on to one of their credit cards. When banks deploy their own money in order to pay an overdraft, then this does not usually impact a client’s credit score. As credit cards are utilized to cover overdrafts, this could increase the client debt to the amount where the credit score became negatively impacted. This does not directly result from checking account overdrafts however.

The problem comes when the overdrafts do not become repaid in a prearranged time frame. The bank might opt to hand over the account into the hands of a collection agency. Such a collection activity might negatively impact the credit score if it becomes reportable to any or all of the three primary credit agency bureaus of TransUnion, Experian, or Equifax. This comes down to how the collection agency reports its accounts to the agencies. It will determine whether the overdraft protection on a checking account shows up as a problem or not.

Such Overdraft protection will deliver a useful tool to help manage the checking account on a day to day basis. For example, a person might easily forget that they drew out money for a Starbucks or Costa Coffee run. The overdraft protection will make sure that the ATM is not turned down or that the ATM Debit card purchase does not get rejected at the merchant point of sale. Banks will commonly assess an overdraft fee and use this to make money from the convenience they are delivering. This is why such protection should not be too commonly used and over-utilized. Instead it is to be reserved for emergency needs and situations.

Every overdraft protection dollar amount is not equal. Each bank and type of bank account will vary the level of protection they deliver. This could also vary on a case by case basis. When such protection is overused, the bank or other financial institution may simply elect to remove the courtesy off of the bank account. Getting it reactivated after such a penalizing move is never easy.

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The term 'Overdraft' is included in the Laws & Regulations edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.