Back to learn
Why do overdraft fees exist?
Written By
Rounding it up
Overdraft fees protect financial institutions from being punished for the overspending of their account holders.
Financial institutions make revenue from charging overdraft fees. Consumer advocacy groups are pushing to limit the number of overdraft fees banks are allowed to charge.
Overdraft fees are a product of convenience for account holders because they allow important payments such as mortgage and utility bills to go through on time, even when the cost of the bill exceeds the amount of money in someone’s bank account.
Overdraft protection services help account holders prevent paying super high overdraft fees. Linking your chequing account to a savings account or credit card can also protect you from paying high fees for overdrafts.
Have you ever opened your bank account and been in complete shock to see that your account is suddenly in the negative? Overdraft fees can make you quickly regret that extra dollar spent on a morning latte. And when you’re broke, getting hit with an overdraft fee can feel like a slap in the face.
In this article, we answer the question “Why do overdraft fees exist?” and give tips on how to avoid them.
Anyone who has ever accidentally overdrafted their chequing account wishes that overdraft fees did not exist. However, they are what some people like to call a “necessary evil”. Though incredibly annoying, overdraft fees do serve an important purpose in the financial world.
Knowing how overdraft fees work and what purpose they serve can help individuals make smart financial decisions and avoid paying high fees in the future.
What Are Overdraft Fees?
Most modern banking institutions offer overdraft protection on chequing accounts. Overdraft protection means that if you don’t have enough money in your chequing account, the transaction can still go through. An overdraft fee is charged to your account each time you make a purchase that exceeds your account balance.
Overdraft protection is a form of credit. When you make a purchase that you do not have the money for, overdraft protection prevents the transaction from being declined. The financial institution charges an overdraft fee in exchange for lending you the money to complete the purchase. Some financial institutions charge a monthly fee for overdraft protection or a pay-per-use fee.
Overdraft protection can apply to various scenarios to prevent you from facing the inconvenience of declined transactions. For instance:
Debit card purchases: Overdraft protection can cover you when you are at a store and the debit card transaction amount exceeds your account balance. An example could be the unexpected high cost at a grocery store checkout.
Cheques: An essential payment through cheques can be covered under overdraft protection. If there are insufficient funds when the recipient cashes your cheque, the bank covers the amount, saving you from a bounced cheque situation.
Withdrawals: If you need to withdraw cash from an ATM and your account is short, overdraft protection will cover the disparity, allowing you access to the money you need.
Transfers: Fund transfers, such as sending money to a friend or family member when your account lacks sufficient balance, can be facilitated with overdraft protection.
Pre-authorized bill payments: Overdraft protection can cover your pre-authorized bills such as automatic utility payments, ensuring your bills are paid on time and without penalty.
If you overdraft your account too many times, your banking institution may turn off overdraft protection and decline future purchases. Most banks offer overdraft protection up to $300, but this amount may vary depending on your credit and income. Improving your credit can get you a higher limit on overdraft protection.
Overdraft protection is limited to ensure that people do not overdraft their accounts beyond what they can pay off in a short period of time. The overdraft limit is often partially based on the amount of your average paycheque and the frequency that you get paid.
Overdraft fees can vary depending on the financial institution and account type, but the average overdraft fee is around $35.
It’s safe to assume that most people overdraft their accounts by accident. Most people who know how to manage their finances know that it is best to avoid spending more money than you have. However, sometimes having the option to intentionally overdraft your chequing account can be a huge benefit.
If you need to purchase a prescription medication or you have an important bill that needs to be paid before payday, facing the overdraft fee may be a better option than not being able to pay for immediate needs.
Why Do Overdraft Fees Exist?
Overdraft fees protect banks from liability for overspending
Banks make substantial revenue from collecting overdraft fees
Overdraft fees help to incentivize people to not overdraft their accounts
In the past, banks would simply decline purchases if there wasn’t enough money in the account. With the growth of computer software and new technologies being used in banking, most financial institutions began to adapt overdraft protection policies. It’s now standard for most major banks to offer overdraft protection (for a fee) for chequing accounts.
Overdraft fees exist to protect banks from financial liability for overspending. While this may seem reasonable, overdraft fees seem to disproportionately affect those who are already struggling financially. Some financial institutions collect huge profits every year solely by charging their customers overdraft fees. While some conveniences of overdraft fees benefit account holders, modern financial institutions now use overdraft fees to gain additional revenue.
Benefits of Overdraft Fees:
Keep cheques from bouncing
Pay important bills on-time
Prevent returned payment fees
Avoid high-interest payday loans
Banks don’t aim to destroy the financial health of their account holders, but they also want to make a profit when they can. Account holders have alleged that some financial institutions use overdraft fees to their advantage by picking and choosing when to apply them. Several Canadian courts have tried cases alleging that charging too many overdraft fees could be considered downright criminal.
There is a push to limit the number and amount of overdraft fees that banks and financial institutions can collect. The global pandemic has resulted in financial hardships for many, increasing the pressure on financial institutions to charge fewer overdraft fees.
Financial institutions do need to charge certain fees to avoid paying for account maintenance out of their pockets, but overdraft fees should not be used to make a profit off disadvantaged people.
An unprecedented amount of people have been pushed towards alternative banking solutions as a result of the global pandemic and inflation. With more people than ever depending on electronic banking services to pay bills and make essential purchases, there have been numerous consumer complaints about how financial institutions use overdraft fees to create revenue.
Quick tip: Failing to keep a specified amount in the account, called a minimum account balance, can result in banks also charging maintenance fees. To avoid paying maintenance fees for an empty bank account, it is best to try to pay off overdraft fees sooner rather than later.
Overdraft Fees vs. NSF (Non-Sufficient Funds) Fees
Overdraft fees and NSF fees are different though often confused. Overdraft fees apply when you spend more than your account balance but your bank covers the difference, essentially lending you the money. On the other hand, NSF fees are charged when a cheque or automatic payment (ACH) is presented for payment and you don't have enough money in your account to cover it, resulting in the bank rejecting the payment.
How to Prevent Overdraft Fees
It’s in your financial best interest to avoid paying overdraft fees as much as possible. Here are four ways that you can keep from paying overdraft fees!
Have a Budget and Stick to It
This one may seem obvious, but the best way to avoid paying overdraft fees is not to overcharge your accounts. At some point, you may have seen an older lady at the grocery store scribbling in her chequebook after using her debit card. Balancing your chequebook is an old-school practice, but it’s a fantastic way to keep track of how much you are spending.
It is far easier to accidentally overspend with a debit card than it is with cash. Having a physical or digital record of how much you spend daily can help you to be mindful of your spending limits.
Luckily, you don’t have to use a pen and paper to balance your chequebook anymore. There are smartphone apps that you can use to monitor your bank balance, create a budget, and tally your spending.
One of the reasons people’s accounts can end up deep in the negative due to overdraft fees is because they don’t stop at just one overdraft. They may not have any idea that their account is overdrawn and as they continue to swipe the card, each transaction comes with a fee. Catching the first overdraft fee and halting spending can stop overdraft fees from adding up.
Get Overdraft Protection
Most financial institutions offer overdraft protection as a financial product, and overdraft protection can be paid monthly. Think of it as a type of insurance for overdrafting your bank account. You pay a small fee every month for the overdraft protection service and then if you accidentally overdraft the account you do not get hit with a surprise fee.
Some banks don’t charge an overdraft protection fee for any months the account without being overdrawn. KOHO offers a financial product called Cover that caps overdraft fees at $5 per month for accounts with overdraft protection.
Switch to a Prepaid Card
Some people struggle with continually over-drafting their accounts simply because the option is there. If paying overdraft fees is destroying your financial health, you may want to switch to a prepaid debit card.
Do you struggle with buyer’s remorse after paying overdraft fees on nonessential purchases? There’s no shame in admitting that you’re struggling with constantly over-drafting your account. Having a prepaid card can help you to resist the urge to overdraft your account and put yourself in debt from fees.
Link Another Account
A great way to prevent overdraft fees on your chequing account is to link the account to your savings account. This way when you make a purchase that exceeds the chequing account balance, the money gets pulled from your linked account instead of sending your main account into the negative.
Of course, this method of avoiding overdraft fees only works if you have money in the linked account. You can also link your chequing account to a credit card to prevent overdrafts if linking a savings account is not an option. Some financial institutions may charge a fee for this service, so be sure to do your research before linking a savings account or credit card.
Avoid Bounce Check Fees
Bounced check fees, also known as returned check fees or non-sufficient funds (NSF) fees, happen when you write a check for more money than you have in your account. The bank returns the check unpaid and typically charges you a fee. To avoid these fees, monitor your account balance closely, set up low balance alerts, or consider overdraft protection as a backup.
Pros and Cons of Overdraft Protection:
Pros:
Avoid the inconvenience of declined transactions.
Prevent additional charges or late fees from merchants for returned checks.
Able to meet urgent financial needs even with insufficient funds.
Cons:
Overdraft fees can be expensive.
It may encourage bad financial habits, like spending more than what you have.
Not all transactions may be covered.
We hope that these tips for how to avoid overdraft fees will be helpful to you in the future as you build your wealth and financial freedom! A healthy relationship with personal finances starts with adequate financial education and KOHO is here to help. Keep reading our blog posts for more helpful tips and tricks from personal finance experts. KOHO is a leading provider of financial solutions that empower the future of accessible banking.