What is an overdraft fee? Everything account holders should know

An overdraft occurs when an account holder spends more money than they have in their bank account, resulting in a negative balance. The bank charges an overdraft fee to cover that transaction. It's the cost of a temporary, short-term loan from the bank.

Overdraft fees can turn a small mistake into a major financial headache.

Navigating these fees can be confusing, but knowing how they work and how to avoid them is important for financial health. Discover how overdraft happens and learn some simple ways to keep your balance in the black and your money in your pocket.

Table of contents

• How do overdraft fees work?
• Key overdraft fee considerations
• Example overdraft fee
• How overdrafts can impact account holders
• How to avoid overdraft fees
• Send and receive money (with no hidden fees)
• Frequently asked questions

How do overdraft fees work?

In simple terms, the overdraft fee is what the bank charges you for covering an expense you don’t have the funds for. It's a penalty for overdrawing your account. Essentially, it’s the price you pay for using money you didn't have at the time of the purchase.

Overdraft fees aren't just for impulse purchases, though. They can happen with all kinds of payments. Your bank will decide to either approve the charge or decline it.

You must agree to "opt in" to overdraft coverage for many debit card purchases and ATM withdrawals. If you don't opt in, the transaction will likely be declined, marking it as non-sufficient funds.

However, for things like writing a check, automatic bill payments, or certain other transactions, banks often cover the charge and then hit you with the fee, whether you opted in or not.

Key overdraft fee considerations

Understanding the specifics of overdraft fees is important to effectively managing your finances. While the basic concept is simple, the policies and costs can vary greatly depending on your financial institution. Awareness of these differences is essential to avoid unwanted charges.

Here are the key parts of overdraft fees and how they work:

• Fees vary by institution: Overdraft fees are not universal. Some financial institutions charge a flat fee for every instance, while others have significantly lowered or even eliminated them entirely.
• Opt-in rules: For debit card purchases and ATM withdrawals, if you haven’t opted in for overdraft and there isn’t enough money in your account, the transaction simply won’t go through and no fee will be charged.
• Automatic transactions: The opt-in rule does not always apply. Overdraft fees may still be charged for checks, automatic bill payments, or other ACH (Automated Clearing House) transactions, regardless of whether you have opted in.
• Daily and extended fees: Your bank may limit the number of overdraft fees you can be charged in one day. However, some banks charge additional "extended overdraft fees" or "continuous overdraft fees" if your account remains negative for several consecutive business days.
• Recent regulatory changes: The Consumer Financial Protection Bureau (CFPB) has been working to regulate and reduce overdraft fees. Recent regulations for larger banks and credit unions will cap fees at $5 or require institutions to follow stricter lending guidelines.¹

Example overdraft fee

Imagine you have $20 in your checking account. You buy a $5 coffee, leaving you with $15. Later, you swipe your debit card to pay for $35 of groceries. Since you only have $15, you have overdrawn your account by $20.

Your bank may decide to cover the $35 transaction for you. In return, they will charge you an overdraft fee, which might also be around $35 (the fees vary by institution). Your account balance will then be -$20 (the overdrawn amount) minus the $35 fee, for a total of -$55. Now, you owe the bank $55.

How overdrafts can impact account holders

Overdraft fees can add up quickly, creating a difficult cycle to get out of. You get hit with a fee, and then your next deposit goes toward paying it off, which, if that doesn’t cover all the fees, can lead to yet another overdraft.

The fees are often much higher than the amount of the transaction. This can make it hard to catch up and can put a real strain on the best laid money management plans. In some cases, racking up too many fees can even lead to your bank account being closed.

This is why consumers have been pushing back against these fees for years. Many argue that the fees are excessive and unfairly target those already living paycheck to paycheck.¹

How to avoid overdraft fees

Understanding your bank's policies is the first step in avoiding overdraft fees. Many financial institutions offer various ways to protect yourself from these charges. Knowing what options are available can help you manage your account more effectively and avoid unexpected fees.

• Opting out of overdraft: You may be able to tell your bank you don't want them to cover debit card or ATM transactions if you don't have enough money. If you attempt to make a purchase that exceeds your available balance, the transaction will be declined.
• Overdraft protection: Consider linking your checking account to another account, such as a savings account, line of credit, or credit card. Then, if you overdraw, the bank automatically transfers funds from the linked account to cover the cost, avoiding the fee. A small transfer fee or interest on the line of credit may apply.
• Set up alerts: Most banks and digital payment apps allow you to set up low-balance alerts. These are notifications sent to your phone or email when your balance drops below a certain amount. This simple tool helps you stay aware of your spending and add funds to your account before it's too late.
• Check your balance regularly: Staying on top of your finances is key. Checking your balance and transaction history often can prevent you from overspending.
• Keep a cushion balance: It can be helpful to keep a small buffer of money in your account. This extra amount acts as a safety net for any unexpected or pending transactions that have yet to clear.
• Use an account that doesn't charge: Some banks and financial services don't charge overdraft fees. Many online-only banks, for example, have a different approach to overdrafts. Researching and choosing an account with a no-overdraft-fee policy is another option to consider.

Send and receive money (with no hidden fees)

Understanding what an overdraft fee is and how it works is an important part of taking control of your financial health. You can avoid costly penalties by being aware of your balance, setting up alerts, and knowing your bank’s specific policies.

Modern digital payment apps can be a helpful tool in this effort. They can provide instant notifications and a real-time view of spending, making it easier to stay on top of your balance and avoid dipping into the red. When you leverage these features, you can make smarter financial decisions every day.

Learn more about sending and receiving money with PayPal.