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What Is an Overdraft and Does It Hurt Credit Score?
Short Answer
When a customer withdraws or processes a payment for more money than in their bank account, it is considered an overdraft. The overdraft protection is an optional bank service that allows users to link a savings account or a credit card to cover transactions exceeding the account balance up to a limit. While overdrafting may not immediately hurt credit scores, the associated negative balance may impact credit if it stays unpaid for longer.
Many people face financial challenges from time to time. Sometimes life gets messy, and emergency expenses cause the need for overdrafting. For instance, maybe an electrical bill is due on Wednesday, and the paycheck is coming on Friday. In that case, as a last resort, you may use the account that allows overdrafting to make the bill payment on time since there isn’t a sufficient balance in your account at that moment. This gap is paid by the bank as a kind of temporary micro-loan, referred to as an "overdraft," and a fee is charged by them for this service.
In this blog, we’ll discuss what overdraft coverage is, the overdraft protection option, and the impact of overdrafting on your credit.
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Try CoolCreditWhat Is Overdraft?
When an individual spends more money than the available balance in their personal or checking account, it causes a negative balance known as an “overdraft”.
Overdraft Usage Example:
For instance, if you have a $50 balance in your account, but you make a payment for $65, the amount exceeding the account balance, i.e., $65–$50 = $15, is paid by the bank, preventing the transaction from declining.
This means that the transaction does not fail and the shortage is covered by the bank, but the overdrafted amount is charged by the bank later, along with an overdrafting fee.
| Overdraft Fees The bank may charge a steep “overdraft fee," which is typically a fixed amount, i.e., $10–$40, averaging around $35 per transaction in most banks. Additionally, the bank may charge a small daily fee until the negative balance is cleared; however, as per the state/federal laws, most major banks have eliminated or reduced these fees. In different states, these laws also specify a maximum capping amount that a bank can charge. |
What Is Overdraft Protection?
Overdraft protection is a banking service that allows account holders to link a secondary account, including a savings account, credit card, or other credit lines, to cover any overdrafts. This means that when a transaction exceeds the available balance, the shortfall is automatically transferred from the linked account to cover the balance. This prevents the account from accumulating a negative balance. However, the bank may charge a small transfer fee.
Overdraft Protection Usage Example:
If your account balance is $150 and you need to make a $200 purchase, the $50 excess will be automatically transferred to your account from the linked secondary account.
Coverage is generally limited to a preset maximum amount subject to credit eligibility. Banks typically provide overdraft protection from $50 to $1,500+, depending on the type of account (personal or checking), the account holder’s history, and banking policies.
How Does Overdraft Protection Work?
- Opt-In Required: Customers are required to apply with the bank to enable overdraft protection, and based on their requirements, the bank may apply this to daily card and ATM transactions.
- Automatic Transfer: The customers can link the account of their choosing and authorize the bank to automatically pull the amount needed when a transaction overextends the account limit.
- Costs: Although opting for overdrafting helps customers save on overdrafting fees, the bank may usually charge a transfer fee on every automatic transfer, i.e., $12.50 on average per transaction, or free in some banks, depending on the banking policies.
| Can You Overdraft a Credit Card? Yes, if you exceed the credit card limit, it is referred to as "overdrafting," which may occur if you have enabled “over limit protection.” If you have not opted in, the card will decline a payment exceeding the credit card limit. |
Is Getting Overdraft Protection Good?
Overdraft protection acts like a safety net, helping prevent declined transactions, returned checks, and bounce fees. Customers can link their savings or credit card to safeguard against the embarrassment of a card being declined. However, fees can quickly add up if you overdraft frequently, with a $35 fee per transaction, which indicates a need for better budgeting and controlling overspending.
Overdraft Coverage vs. Overdraft Protection: What’s the Difference?
| Criteria | Overdraft Coverage | Overdraft Protection |
| How it Works: | The bank covers the shortfall even if the customer account has $0, leaving the account with a negative balance. | The bank moves money from a linked account (savings, credit card, or line of credit) to cover the gap. |
| Fee charges: | The standard overdraft fee ranges from $10 to $40 per transaction, though many major banks have eliminated these fees. | A low transfer fee is charged, often $0 to $12, as many major banks offer free transfers when overdraft protection is enabled. |
| Impact on Credit: | May not impact credit unless the account is closed and sent to a collections agency. | No impact on credit directly, unless the secondary account gets exhausted frequently, increasing credit utilization. |
| Opt-In Requirements: | Typically requires the customer to opt in. | Requires customers to opt in and provide explicit authorization to transfer funds automatically when needed. |
Does Overdrafting Hurt Credit Scores?
Generally, overdrafts do not directly impact your credit score because, if they remain unpaid for just a few days, banks do not immediately report them to the credit bureaus. But if the negative balance is not cleared and your account gets closed, things can get complicated in a few ways.
Here’s How Overdrafting Can Impact Your Credit:
- ChexSystems Reporting: The banks don’t report their day-to-day activities to the credit bureaus. However, when you overdraft your account, it gets reported to ChexSystems. This can lower your ChexSystems score and prevent you from opening new bank accounts elsewhere.
- Unpaid Balance: If your outstanding balance is more than $100 with overdraft fees included and does not get cleared even after 60–90 days, it can be reported to the credit bureaus and show up as a derogatory mark on your credit report.
- Reported by Collection Agency: If your account is closed by the bank, they may sell the outstanding debt to collections, which reports it to the credit bureaus. This can significantly lower your credit scores.
Worried about Overdrafts Affecting your Score? Build Smarter Credit Habits
Download the AppHow to Protect Your Credit Standing
1. Set up low balance alerts
You can use the mobile app or website to set up low-balance alerts or notifications within settings. This helps you keep track of spending and transfer the essential funds on time.
2. Link multiple accounts to avoid overdrafting
Most banks offering overdraft protection allow customers to link more than one bank account. Hence, you can link a savings account, a credit card, and any other account you may have. You can set the priorities for the fund transfer sequence. Different banks may have different limits on how many accounts you can link. For instance, Wells Fargo usually allows 2 accounts (savings and a credit card) to be linked. Whereas the Bank of America allows up to 5 accounts to be linked. So, make sure to check the policies at your bank.
3. Repay any overdrafted amount
Sometimes expenses may get out of hand, and you may incur an overdraft. But make sure to pay it off at your earliest, i.e., within a few days, along with the overdraft fees. Act early to avoid escalation.
4. Monitor your credit report regularly
Regularly reviewing both your bank account activity and credit report helps you catch issues early. Keep an eye out for any suspicious activity. Additionally, checking your credit report helps you spot any inconsistencies in your credit record. So, if you find any inaccuracies, you can timely flag the issue and raise a dispute with the credit bureau, which helps protect your credit.
5. Strengthen your credit score
You can work at strengthening your credit in the meantime by making timely payments, making adjustments to your budget, and using DIY credit monitoring apps like CoolCredit. It uses AI-powered analysis to highlight the negative items on your credit report and provides tools to resolve them and boost your credit. It also offers expert credit assistance by dedicated professionals on demand. This helps ensure better credit standing in the long-run.
Conclusion
An overdraft sometimes becomes unavoidable when an emergency payment needs to be made. Overdrafting may start as a small shortfall, but if ignored, it can quickly add up in penalty fees, lead to account closure, and even collections. Overdraft protection can be a safeguard you can place to minimize the risk of overdrafting. However, while overdraft protection can act as a financial safety net, relying on it too often can lead to growing fees and complications. The key is to treat overdrafts as temporary support—not a habit—and to address any negative balance before it escalates into a larger issue.
Staying proactive by monitoring balances, spending wisely, and resolving overdrafts quickly can make all the difference in keeping your finances on track. Additionally, using apps like CoolCredit can help you better control your finances and credit health.
FAQs
Q: What Is Overdraft Coverage?
A: Overdraft coverage helps customers overdraw for a transaction up to a specified limit set by the bank. So, even when the account limit gets exhausted, the overdraft coverage provides a secondary safeguard to ensure the payment does not fail.
Q: How Long Do You Have to Pay Back an Overdraft?
A: You generally have 1 to 2 business days to repay an overdraft to avoid fees (often called a "grace period"). If fees are applied, you usually have 30 to 60 days to clear the balance before the bank closes it and sends the debt to collections.
Q: Can I Overdraft My Account by $1000?
A: Different banks may offer different overdraft limits. So if your bank account has an overdraft limit up to $1,500, then you may be able to overdraft a $1k amount. However, it may impact your credit if you leave it unpaid for long.
