Overdraft limit: A financial lifeline or a debt trap?

It can take surprisingly little for unplanned fees to nickel and dime away your money. When you know what fees you might face and how to avoid them, you can keep more of your money safe.

Take overdrafts. Your bank might allow you to spend more than the amount that’s in your checking account, up to your overdraft limit—typically for a fee. But overdrafting is something you can often 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.

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 an overdraft limit, and how much can you overdraft?

Most banks set a limit on how much you can overdraw your account. So you could overdraft up to that limit, but no more. The best way to find out your overdraft limit, if you have one, is to ask your bank, or verify the limit in your account agreement or banking app.

Banks may 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. Banks often report account closures to screening companies such as ChexSystems and Early Warning, which could limit your ability to open a new account with another bank.

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.

Changed your mind since then? You can generally opt into or out of overdraft coverage at any time by telling your bank.

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

Fees vary by bank, and many banks and credit unions charge $30 or more per transaction. A 2023 CFPB report found that the median overdraft fee is $35 among large banks and credit unions that charged overdraft fees.

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. Banks reported about $5.8 billion in overdraft and NSF fee revenue in 2023, according to a report from the CFPB.

Banks set their own overdraft fees, and they could charge multiple fees per day. Some banks and credit unions may charge an additional fee, sometimes called an extended or sustained overdraft fee, if you don’t bring your balance back above zero within a few days. 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 could pay three overdraft charges. If the transactions post in the opposite order, however, the two smaller ones would clear and you’d only 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 into 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 may hurt you more than it helps.

Banks may offer a variety of overdraft options:

• Standard overdraft coverage: Your bank pays the transaction and charges you an overdraft fee.

• Linked savings account: Money moves from savings to cover the gap. Your bank might charge a transfer fee, typically lower than an overdraft fee.

• Overdraft line of credit: You borrow to cover the shortfall and pay interest on that amount, plus a possible fee.

• No coverage: If you opt out, your bank generally declines ATM and one-time debit card transactions that would put you over your balance, with no overdraft fee.

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. A 2023 CFPB survey asked people whether their household got charged an overdraft or nonsufficient funds (NSF) fee in the past year. Among those with household income under $65,000, 34% said yes.

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 draw from.

• 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.

• Know when scheduled payments like utilities come out and when deposits become available, so a payment doesn’t post before your paycheck clears.

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

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

A little planning and a realistic budget could help you avoid surprise fees.