Almost one in three Americans overdraws their checking accounts occasionally, and 5 percent of us are chronically overdrawing our accounts and relying on the money for essential spending. An overdrawn account will land you with some extra costs and interest charges that are never fun. The consequences can be much more severe if you fail to repay the overdraft and your account stays in a negative balance.
TL;DR (Too Long; Didn't Read)
Every time your account becomes overdrawn, you'll have to pay an overdraft fee plus interest on the overdrawn amount until the account balance is positive. Fail to pay back the overdraft, and the bank may send the account to collections; this will harm your credit score.
How Do Overdrafts Work?
An overdraft is an ongoing line of credit on your checking account that allows you to take out extra cash even when your account has no money in it. So, if you have $50 in your account and you try to spend $75 – and the bank allows the transaction to go through – then your account will be overdrawn by $25.
What's happening here is that the bank is lending you a set amount of money. As with any loan, you'll pay interest on the overdrawn amount at the bank's overdraft rate. Most banks will also charge a one-time "non-sufficient funds" (NSF) fee per transaction, somewhere in the region of $35, although some institutions may charge a fee for every day your account is overdrawn.
What Are the Advantages of Overdrawing?
When you absolutely need to spend money – to make an unexpected payment for example, or take advantage of a significant discount on something you wish to buy – but your account balance is close to zero, then having an overdraft allows you to pay for what you need. It can be a life saver if the alternative is missing a bill payment and racking up late fees or debt collection activity.
What Are the Dangers of Overdrawing?
Overdrafts can get very expensive, very fast, so it's important to use them as short-term buffer in an emergency. Americans pay nearly $17 billion in overdraft fees each year, according to Consumer Financial Protection Bureau, and on top of the overdraft fee, you'll be charged interest on the overdrawn amount at the bank's published rate. These rates can be very high – over 20 percent in some cases.
You'll get stung for interest on the loan amount until you bring the account to a positive balance. Interest charges can rack up fast if you don't pay have a repayment plan, making it tough to get out of overdraft dependency.
Will an Overdraft Affect My Credit Score?
Overdrafts do not get reported to credit bureaus, so the occasional mistake will not impact your credit score. However, if the bank covers your overdraft, you typically have a maximum number of days or weeks to pay the money back – around 30 days is a common time frame. Miss the repayment deadline, and the bank may send the overdraft to collections.
Collection activity almost always will harm your credit score, and the activity will stay on your report for seven years. Having a low credit score can hurt you financially as you could be classified as a high-risk borrower. Lenders tend to deny credit to high-risk borrowers and you may no longer qualify for the best rates.
Overdrafts and Debit Bureaus
While overdrafts are not reported to credit bureaus, they are reported to debit bureaus. Debit bureaus collect and report information about your checking and savings accounts, and banks will normally review these reports when someone applies for a checking account or other financial products like certificates of deposit or mutual funds. If you are habitually in overdraft territory, this could reduce the bank's willingness to extend a bank account, line of credit, personal loan or other types of finance. As such, it will be cheaper in the long run to control your overdrafts and find others ways to keep a positive balance on your checking account.
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.