Understanding the advantages and disadvantages of overdrafts depends on your definition of overdrafts. Most commonly, an overdraft occurs when you spend more money in your checking account than you have, either by writing checks for more than the balance in your account or by using your debit card when there are insufficient funds in your checking account.
How Do Overdrafts Work?
To avoid overdrafts, some banks offer various forms of overdraft protection, some of which can be beneficial and some of which can be downright costly. Therefore, you need to know specifically what is meant by overdrafts and overdraft protection when considering the advantages and disadvantages of overdrafts.
An overdraft can occur any time you spend money that isn't in your account. Without overdraft protection, your debit card is declined or the check that you wrote will be returned to you for insufficient funds instead of being honored. Overdraft protection is offered by banks as a way to avoid bouncing checks or a declined debit card.
Overdraft protection is oftentimes applied to checking accounts automatically by financial institutions, but 2010 changes to banking regulations require account holders to specifically opt in to overdraft.
Potential Advantages and Disadvantages of Overdrafts
Overdrawing your account has no real advantages. You are almost always charged some type of fee when you overdraw your account, and it may also be seen as a sign of poor money management by your bank, which may result in your bank being reluctant to extend you loans or lines of credit later if you need them.
Types of Overdraft Protection
The advantages of overdraft protection vary depending on what you the overdraft protection entails. Automatic overdraft protection from the bank often simply means that the bank won't decline your card or bounce the check. Instead, they will honor the transaction despite the fact that you are spending money that you don't have. You will need to deposit money into the account to pay for both the overdraft and the overdraft fee, otherwise you may be charged additional fees for the time when your account is in the negative.
You can also set up overdraft protection with your bank. This involves linking your account to a credit card or savings account. Money is then moved from the credit card or from the savings account to cover the overdraft. Many banks also charge a fee for this service, but the fee may be less than other forms of overdraft protection. You also avoid having a negative account balance if you opt for this method.
Some banks offer a line of credit in which you automatically borrow money from the bank for overdrafts and are charged interest to cover the borrowed funds.
The major advantage of overdraft protection is that your card isn't declined and your checks don't bounce. This helps you to avoid embarrassment from a declined credit card; imagine, for example, being at the grocery store with a cart full of groceries and no way to pay because your card has been declined. This can also be helpful if you have a payment that really can't be late, such as a mortgage payment; instead of having the check returned and experiencing hefty late fees from the lender, you simply pay one overdraft fee to your financial institution.
If you have overdraft protection that allows you to link your account to a credit card or line of credit, the other advantage of this type of protection is that you may be charged less or not even charged fees at all when you overdraft your account.
The two major disadvantages of overdrafts are the fees charged and the damage that multiple overdrafts can do to your relationship with your bank. If you want to avoid these fees and costs, you can talk to your bank about setting up a less expensive form of overdraft protection. You can also consider opting out of overdraft protection entirely and instead having your card declined if you try to use it when you don't have enough money in the account.
The best thing to do is to avoid overdrafts entirely. Do this by creating a budget, keeping an extra cash cushion in your account, managing your checkbook and checking your balance before making a purchase or writing a check.