An overdraft is a feature provided by banks to their account holders that allows the account holder to withdraw more money than they actually have in their account. In other words, an overdraft provides the customer with a form of credit.
When a person’s bank account balance falls below zero, they have ‘overdrafted’ their account. Depending on the specifics of the banking relationship, the bank may or may not allow a transaction that will cause the account to go into overdraft.
There are typically fees associated with overdrafts. The bank may charge an overdraft fee each time a transaction is allowed to go through that results in a negative balance. Some banks offer overdraft protection services that will automatically transfer money from a linked savings account or credit line to prevent the account from going into overdraft.
However, the practice of allowing overdrafts and charging high fees for them has been the subject of criticism and regulation in some jurisdictions. Critics argue that these fees can create a debt cycle that is difficult for people to escape from, particularly those who are financially vulnerable.
Please note that while an overdraft can provide short-term relief in case of a financial crunch, it’s usually not a good idea to rely on them for long-term borrowing due to the high fees and interest rates associated with them.
Example of an Overdraft
Suppose you have a checking account with a balance of $100. You use your debit card to make a purchase that costs $120.
If your bank does not offer overdraft protection, or if you have not opted into it, your transaction would typically be declined because you don’t have enough money in your account to cover the cost.
However, if you have opted into your bank’s overdraft service, the bank will cover the extra $20 needed for your transaction, and your account balance will go into negative, say -$20.
The bank, however, will charge an overdraft fee for this service. Let’s say the bank charges $30 as an overdraft fee. So, after the transaction, your account balance would be -$50 ($20 for the overdraft amount and $30 for the overdraft fee).
Overdrafts can be helpful in emergency situations where you need to make a transaction and don’t have enough funds in your account, but they can become costly due to the associated fees.
In the next few days, you will have to deposit at least $50 into your account to bring your balance back to zero, not considering any daily fees that some banks charge for every day your account remains overdrawn. It’s advisable to be aware of your bank’s fee structure and to manage your account carefully to avoid going into overdraft whenever possible.