How Overdraft Fees Work and How to Avoid Them

Overdraft fees can seem inescapable. Top banks charge a median fee in excess of $30 whenever you spend or withdraw more money than is available in your checking account, unless you've opted into an overdraft protection program with a linked account or line of credit. Since a substantial portion of banks’ revenue comes from overdraft and non-sufficient fund (NSF) fees, it isn't a surprise that financial institutions haven’t worked too hard to eliminate them.

Banks use a questionable process known as reordering to maximize overdraft fees, processing the largest checks, ATM withdrawals and debit card transactions first, rather than in the order in which they were received. In turn, this triggers negative balances and overdraft fees more frequently.

Here's how reordering can hurt you:

You take $100 out of the bank and the ATM says you have $62 left in the account but the bank decrees you've overdrawn and charges a fee. How can the bank do this when the machine says you have money left in the account? This is happening because the bank has reordered the way it processes your checks: For example, it first charges the big rent check that arrived after your withdrawal. This check eats up the $62 balance and leaves the account overdrawn when your $100 withdrawal is processed.

While it can be a challenge to avoid these charges on your bank statement, there are sound strategies for keeping your hard-earned money where it belongs ... in your pocket.

When a bank offers overdraft coverage, it means you’ll be able to make a purchase with your debit card or withdraw from an ATM even if you don’t have the full amount available in your account. That can save embarrassment at the lunch counter but you’ll incur a hefty overdraft fee – or run up interest if your bank offers an overdraft line of credit to cover charges until you pay them back. 

A 2010 Federal Reserve rule prohibits banks from automatically providing overdraft coverage to their customers. Now, you must opt in to have your debit card purchases or ATM withdrawals covered by your bank or they’ll be declined. If you prefer the possibility of a rejected debit card over a one-time fee, contact your bank and choose to forego overdraft coverage on your checking account. But be warned that, even when you opt out, most banks will charge non-sufficient fund (NSF) fees that can equal overdraft fees. 

If you don’t want the hassle of having to opt out of overdraft protection, switch to a checking account that prides itself on eliminating overdraft fees altogether. In most cases, the bank will decline to cover the attempted charge or ATM withdrawal but not charge a NSF fee. There are tradeoffs because most no-fee checking accounts don’t accrue interest and the majority of participating banks are Internet-based, with no option to bank at a brick-and-mortar branch.

Many banks offer the option to link your checking account with another bank account so that, when you overdraw, the payment will be covered by your own funds. You’ll avoid the bigger overdraft fee but be charged a modest transfer fee ($10 to $15 is common). Some banks will also let you link your credit card to your checking account to serve as the cushion for overdrafts. If you go that route, it will likely be treated as a cash advance, incurring an immediate interest charge on top of the transfer fee. 

Knowledge is power when it comes to your bank account. If you know ahead of time that your balance is dangerously low, you can transfer funds into your account or skip that impulsive purchase until your next paycheck. Most banks with online or mobile banking capabilities will allow you to set up an email or text alert when your balance drops below a pre-defined threshold – $200, for instance. You can also choose to get an alert whenever a deposit or withdrawal posts to your account so you know when your balance is in trouble.

Even better, opt in to a daily email that shows your current balance. It won't protect the account against reordering, but you’ll have a clearer picture of how closely you need to watch your spending habits.

Overdraft fees can be an unnecessary strain on your pocketbook. Banks make billions of dollars per year from customers overdrawing their accounts, with those who can least afford the fees often getting hit the hardest. But with a little extra vigilance and the right checking account, you can be fee-free and make the most of your money. For more, see Pros and Cons of Overdraft Protection.