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FAQ: What is the Overdraft Protection Law and How Do Overdraft Fees Work?

July 26, 2012

Overdrafts occur when a customer makes a transaction using more funds than are currently available in his or her checking account. When the customer overdraws, whether it is through a bounced check, debit card purchase or ATM withdrawal, the bank can either process or reject the transaction, and the bank’s behavior depends on what option you chose when you signed up for the account.

Customers currently have three options regarding overdrafts for a checking account:

  1. Do not opt into any plan and have the transaction immediately rejected by the merchant if the account lacks sufficient funds. This is the default setting when a bank account is opened, and no fee is incurred by a rejection of the transaction.
  2. Opt into overdraft coverage and pay an overdraft fee, usually around $35, when the bank processes the transaction resulting in a negative account balance.
  3. Opt into an “Overdraft Protection” plan in which the bank processes the transaction and transfers funds from a linked account or credit card to the checking account for a fee of $10-$12. Essentially, this is an automatic funds transfer option, but to utilize this the customer would need to have sufficient money in their savings account or qualify for a line of credit.

If a customer chooses not to opt into any plan and overdraws the account, the transaction will be declined by the merchant and the customer will not be charged a fee. If a consumer chooses to opt-in to an overdraft plan, most banks offer the option of choosing between overdraft protection or overdraft coverage.

What is the Overdraft Protection Law?

Before the Overdraft Protection Law was passed, most banks automatically enrolled customers in overdraft coverage. These banks automatically processed transactions when customers had insufficient funds, and they charged a fee of around $35 for each of these transactions.

The rules changed in 2010. Beginning July 1, 2010 for new accounts and August 15, 2010 for existing accounts, the Federal Reserve prohibited banks from automatically enrolling customers in overdraft coverage. This law declared that the default setting for an account must be a rejection of the transaction by the bank if the account lacks sufficient funds, but customers may opt into overdraft coverage if they wish. The law requires flexibility from the banks, stating that customers must be able to opt in or opt out at any time.

This law only applies to transactions that are not preauthorized, such as ATM withdrawals and debit card transactions. Pre-authorized withdrawals, such as automatic bill payments and checks, do not fall under the umbrella of the Overdraft Protection Law and still can still lead to an overdraft fee.

What is the “Overdraft Protection” option offered by banks?

Overdraft Protection is a common bank service that links a checking account with a line of credit, savings account, credit card, or second checking account. Bank of America states, “The service gives you more flexibility to make purchases when you don’t have enough money in your checking account at the time of the transaction. Be sure to keep enough funds in your linked account. Overdraft Protection helps prevent declined transactions, returned checks or other overdrafts on your accounts.” This service automatically transfers your own funds between linked bank accounts to cover overdrafts, charging an overdraft transfer fee of $10-$12.

Overdraft Protection has been criticized for targeting those who live paycheck-to-paycheck. A Pew study found that consumers earning less than $30,000 a year were twice as likely to suffer overdraft fees than those who make more. Therefore, customers who feel they need overdraft protection to ensure they are not declined in a tight situation are likely the same customers who end up incurring the most fees.

Although customers now need to opt-in to overdraft coverage or overdraft protection, heavy marketing campaigns by banks (as outlined in Businessweek) and a lack of transparency have resulted in a dearth of financial literacy regarding overdraft fees. The aforementioned Pew study found that more than half of overdrafters in 2011 did not know they had opted into an overdraft setting, resulting in an estimated $16 billion in overdraft fees that year.