Overdraft limit: A financial lifeline or a debt trap?

Understanding the costs of banking is an important step toward becoming financially savvy. When you know what fees your bank charges and when those charges come in, you’re on your way to keeping better tabs on your cash. 

Take overdrafts. Your bank might allow you to spend more than the amount that’s in your account, up to your overdraft limit and typically for a fee. Overdrafting is something you may be able to avoid through budgeting and planning. If you manage to steer clear of overdrafts, money’s not the only thing you’ll save. You could also protect your standing as a good customer with the bank.

Related: Use this free budgeting app to help you increase your money left over and avoid overdrafts

How do overdrafts work?

An overdraft is when your bank processes a transaction for more than the amount of money in your account. This creates a negative balance in your bank account. You now owe the bank money just to get back to zero.

The most direct consequence of overdrafts is getting hit by fees. Fees could make it even harder to catch up on the cash shortfall that caused the overdraft in the first place. 

Overdrafting too often or too deeply could also jeopardize your standing with your bank and cause them to drop you as a customer.

What is the overdraft limit?

Most banks set an upper limit on how much you can overdraw your account. It’s generally in the range of $100 to $1,000. Banks could also set different policies for what happens when you reach that ceiling. Your spending may be limited until you repay the overdrawn amount, and your account may even be closed in some cases. If your bank account is closed because of overdraft fees, it could be hard to open another one. 

Related: This bank account surprise could throw your budget off track

What are overdraft fees?

Overdraft fees are charges that many banks tack onto your account if you spend more than what’s available in your checking account. Behind the scenes, your bank pays the amount for you, and the payment goes through anyway. This convenience usually comes with a price: an overdraft fee.

Banks are required to get your permission before charging an overdraft fee for certain types of transactions, like using your debit card or getting cash from an ATM. You might remember signing an overdraft form when you opened your account. This form asked you to opt in or turn down overdraft coverage.

Even if you opt out, banks could still charge you overdraft fees for some types of transactions, such as loan payments set on autopay. 

Banks vary in what they charge you for an overdraft, but it could be anywhere between $10 and $40. The average fee is about $35.

What types of overdraft fees are there?

You do have to give permission to the bank for certain overdraft charges, but other than that there aren’t a lot of rules about overdraft fees. Some banks have taken advantage of this legal flexibility and used overdraft fees as a major source of income. 

Banks set their own overdraft fees, and they could charge multiple fees per day. They may charge overdraft fees for every day you go without getting your balance positive again. If this happens, you could fall into a debt trap.

In addition, some banks post your transactions from largest to smallest. If you don’t have enough money to cover all of your transactions that night, you could get hit with multiple overdraft fees. Here’s how that looks. 

Let’s say your balance is $200, and three transactions post to your account:

• $225 for a medical bill

• $100 for car repairs

• $25 for brunch with friends 

If your bank processes the transactions in this order and doesn’t return any of the transactions unpaid, you’ll pay three overdraft charges. If the transactions post in the opposite order, however, the two smaller ones will clear and you’ll only have to pay for one overdraft. 

It’s a good idea to review your account agreement or ask your bank what to expect.

Is it a good idea to opt in to overdraft protection?

Having the option to overdraft your account could be helpful if you reserve the perk for rare emergencies. However, if you depend on overdrafting because you often run short of money in your account, overdrafting could hurt you more than it helps.

Lower-income households are more likely than higher-income households to pay fees for overdrafting their accounts or having a transaction denied because of insufficient funds. If you live paycheck-to-paycheck, getting hit with bank fees could make financial hardship even worse. 

How to avoid overdraft fees

You have a lot of options for avoiding overdraft fees. If you use these strategies, you’ll be less likely to bump up against your overdraft limit:

• Set up low-balance alerts on your account

• Take a refresher course on your bank’s overdraft policies 

• Try to save up a larger buffer in your checking account, and an emergency fund you could tap into.

• Consider switching to a bank that doesn’t charge overdraft or NSF fees

• Keep tabs on your monthly budget, especially big upcoming expenses like rent

• Consider opting out of your bank’s overdraft coverage or linking up a savings account to cover overdraft spending

• Look for banks that offer early direct deposit for your paycheck or grace periods to repay overdraft charges

Read more: How to budget like a boss