Overdraft protection

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Overdraft protection is a financial service offered by banking institutions primarily in the United States. Overdraft protection advances money to cover an attempt to withdraw money from an account that does not have sufficient funds. Overdraft protection can loan money to cover ATM withdrawals, purchases made with a debit card, electronic transfers, and checks. When used to cover checks, overdraft protection prevents the check from bouncing; when used to cover other transactions, it allows the consumer to borrow money through a withdrawal.

1 Types of overdraft protection
2 Costs
3 Benefits and risks
4 Federal regulation
5 External links

[edit] Types of overdraft protection

Ad-hoc coverage of overdrafts: Traditionally, the manager of a bank would look at the bank's list of overdrafts each day. If the manager saw that a favored customer had incurred an overdraft, he had the discretion to pay the overdraft for the customer. Banks traditionally did not charge for this ad-hoc coverage. However, it was fully discretionary, and so could not be depended on.

Overdraft lines of credit: This form of overdraft protection is a contractual relationship in which the bank promises to pay overdrafts up to a certain dollar limit. A consumer who wants an overdraft line of credit must complete and sign an application, after which the bank checks the consumer's credit and approves or denies the application. Overdraft lines of credit are loans and must comply with the Truth in Lending Act. Banks typically charge a fee ranging from $0.50 to $5.00 per overdraft, and also charge interest on the outstanding balance. Some banks charge a small monthly fee regardless of whether the line of credit is used. This form of overdraft protection is far less expensive than bounce protection and available mainly to consumers with good credit.

Linked accounts: Also referred to as "Overdraft Transfer Protection", a checking account can be linked to another account, such as a savings account, or to an existing line of credit, such as a credit card or home equity line of credit. Once the link is made, when a consumer starts a transaction that would result in an overdraft, the money to cover the overdraft is taken out of the linked savings account or linked line of credit. A fee of a few dollars is usually charged for each transaction, and the consumer must pay interest under the terms of the existing line of credit. The main difference between linked accounts and an overdraft line of credit is that the creation of linked accounts does not require a new credit application as long as the consumer already has a savings account, a credit card, or other line of credit.

Bounce protection: The newest and most controversial variety of overdraft protection, "bounce protection" is a hybrid between an overdraft line of credit and ad-hoc coverage of overdrafts. A bounce protection plan is much like an overdraft line of credit, except that the bank reserves the right to refuse to cover overdrafts at any time and without warning. Bounce protection can alternatively be characterized as an automated version of ad-hoc coverage of overdrafts: the bank programs its computers to automatically cover overdrafts if certain conditions are met.

Bounce protection plans cover withdrawals made through debit card transactions, ATM withdrawals, electronic transfers, and checks. Banks typically charge a one-time fee of between $25 and $35 for each overdraft paid. A bank may also charge a recurring daily fee for each day during which the account has a negative balance.

Banks argue that the money advanced to customers is not a loan because of the "discretionary" character of the overdraft protection. Critics argue that any time funds are advanced to a consumer and repayment is expected, a loan has occurred. "Bounce protection" is not covered by the Truth in Lending Act, which prohibits certain deceptive advertisements and requries disclosure of the terms of loans. Bounce protection can be added to a consumer's account without his or her permission, and without informing the consumer.

"Bounce protection" has been adopted by banks throughout the United States in an effort to increase fee income. Banks have been accused of a wide rance of unfair, deceptive, and predatory practices in connection with their bounce protection programs, leading to calls for increased federal regulation to close what critics see as "loopholes" that allow banks to offer loans without providing the disclosures normally required for loans.

[edit] Costs

As a source of revenue, banks have the option of charging a fee for every use. Fees vary widely depending on the bank and on the kind of overdraft protection used, ranging from a few cents to over thirty dollars USD.

There may also be interest costs. Essentially, overdraft protection provides an instant, high-interest loan to cover the amount of the check, although banks argue that bounce protection is not a "loan" as defined by the Truth in Lending Act. This loan is meant to be paid off quickly, as even a short period of inaction can be financially devastating to the customer.

Some banks arrange their overdraft protection program to pay the largest check first, in order to increase the number of overdrafts and maximize fee income.

[edit] Benefits and risks

If corrected in a timely manner, the costs of overdraft protection are typically lower than the fines incurred for bouncing a check. For a bounced check, the bank will charge the customer a nonsufficient funds fee (NSF) and the cashing institution will charge a returned check fee, sometimes in addition to the amount of the check. This package of fines may be dramatically higher than the single overdraft protection fee.

The costs of overdraft protection are typically far higher than the costs of attempting make a purchase with a debit card or make an ATM withdrawal from an account with insufficient funds. In the absence of overdraft protection, such ATM withdrawals and debit purchases are refused without a fee. The consumer then may choose to cancel the transaction or to borrow money from a less-expensive source, such as a credit card lender or pawn shop.

For checks, overdraft prevents the cashing institution from knowing that the person is low on cash. This is especially useful if the cashing institution is a business partner or relative.

If the overdraw is not corrected within a short period of time, however, overdraft protection may do more harm than good. If the overdraft protection program charges interest for the loan, the interest will accumulate quickly, leading to potential financial ruin, which is also possible from daily recurring fees. Overdraft protection often causes customers to fall into a "trap" or cycle that is difficult to overcome. This is a similar circumstance to the cycle that occurs in payday lending.

[edit] Federal regulation

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On June 1, 2005, financial regulators within the United States government proposed new regulations that would prevent banks from misleading customers about overdraft protection. In particular, some banks have been shown to advertise overdraft protection as simply a regular line of credit, instead of a last ditch line of defense against bouncing checks. Habitually using overdraft protection is dangerous, considering its high interest rates.