How an Overdraft Loan or Line of Credit Works

Chang Fu
November 21, 2019

Overdraft loans and overdraft lines of credit are essentially just a form of overdraft coverage or an overdraft protection transfer offered by banks. These forms of “credit” can be expensive and many times, it is best to find ways to avoid overdraft loans and overdraft lines of credit from banks. However, payday loans and other forms of short-term credit may also not be the best solution so understanding what this is, how to avoid it, and what to do will help you make the best decision for you.

Possible recently completed a round of user research in which we debunked a common misconception that users had little to no bank fees and charges, when in fact they were paying hundreds of dollars in fees to banks. While most banks offer free checking and savings accounts (though sometimes requiring a minimum balance),it can be easy to assume that since the account itself is free, there are no fees incurred by the bank account.

Instead, we found that users of Possible are incurring significant fees in their checking and savings accounts, mostly in the form of Non-Sufficient Funds fees (also called Insufficient Funds fee; abbreviated NSF fee) and Overdraft fees. These fees are approximately $35 (though they can vary from bank to bank and account type to account type, $35 seems to be about the average), and can quickly compound into the hundreds of dollars. Tragically, this happens most often when money is tight, often at the end of the month. Here is a chart of overdraft fees, provided by smartasset.com:

Overdraft fees at popular banks (members of FDIC)

  1. Bank of America, $35
  2. Chase Bank, $34
  3. Citibank, $34
  4. PNC Bank, $36
  5. Santander Bank, $35
  6. TD Bank, $35
  7. US Bank, $35
  8. Wells Fargo, $35

Overdraft and NSF fees are incurred when you spend more money than you have in your bank account, most often in your checking account. For instance, this happens when you attempt to use more money than you have available funds. Some examples are: paying from your debit card, withdrawing money, writing a check, or making an online transfer when you don’t have the money to cover the cost. When you have a checking account overdraft, your bank can choose to cover the extra amount as part of their overdraft policies, even without your consent, including charging and additional fees. Your bank does have a legal requirement to ask you if you want to be covered in the event of an overdraft, and we recommend not opting in. You do not need to authorize overdrafts if you do not want it. This means your transactions are rejected with no cost to you, preventing costly overdraft fees altogether. This may not be realistic for everyone, as sometimes you need the money to cover rent, food, bills, or other essential expenses.

How to Avoid a NSF and Overdraft Fee

If you do decide to opt into an overdraft program, you generally have two options: overdraft coverage or overdraft protection transfer.

Overdraft coverage, also referred to as “courtesy pay” or “overdraft privilege,” is the most expensive option. This allows your bank deposit account current balance to drop below zero, and is essentially an “overdraft loan” or “over draft loan” — your bank “loans” you an amount of money at a flat $35 fee (this still can vary from account to account and bank to bank, but $35 seems fairly standard; see list above) and then requires you to pay it off the next time you deposit into your account, much like a payday loan, except automatic and provided by your bank. If you overdraft just $5 for a week, a $35 fee is the equivalent of a whopping 36,400% APR loan (52 weeks x $35/$5)! Using an installment loan through Possible to cover the difference between your current finances and the amount you need in a given month can lower this APR to as low as 151%, 244 times less than an overdraft fee.

The other common option is overdraft protection transfer which can usually be requested via an opt-in form with your bank. This connects your checking account to another account, like a savings account or a money market account, and sometimes even a personal line of credit so that when you overdraft your checking account and your available balance is below 0, money transfers from your linked account rather than incurring a more expensive fee. These overdraft protections do often incur a $10 to $12 fee (which is cheaper than the $35 overdraft coverage program, but not insignificant), so they’re not a silver bullet for avoiding overdraft and NSF fees. Many of our customers don’t have excess funds in another account, so this is not a good solution for everyone. And even a $10 to $12 fee has an APR in the thousands of percentage points!

The best option for savvy bank account holders and customers is not opting into overdrafting a checking or savings account at all. This will also prevent you from ever having an overdrawn personal checking account or savings account. It will mean that transfers from the affected accounts will not go through – same with purchases on your debit card in line at the store and withdrawals at the ATM. You may even have a returned item or two. While these circumstances can be embarrassing and cause you to not be able to purchase goods or services you need, they are considerably less expensive than the fees you incur from overdrafting or insufficient funds. If you opt to go this route, you’ll need to find an alternative method for obtaining the funds you need to make it between paychecks; it doesn’t help at all with covering unexpected expenses like a car accident or medical emergency. We’ll discuss possible solutions to this problem towards the end of the article. This also requires discipline and focus, to avoid having your debit card declined in the grocery store line.

Another solution is a prepaid debit card. This has the same drawbacks as overdraft protection transfers and not overdrafting at all; in particular, once the balance of the prepaid debit card is out of funds, the debit card is declined wherever you try to use it. For customers who have insufficient funds to make it between paydays, this may not be a viable option. You may choose to combine this with other types of loans to help you regulate your spending; for instance, a payday loan or an alternative payday loan from Possible can be a strong financial choice to avoid the high APR of overdraft fees. This can help regulate spending throughout the month, help make ends meet when money is tight, and make it impossible to overdraft. In addition, by building credit history, you’ll be improving your long-term financial health.

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Getting an overdraft loan or line of credit

Overdrafting from a personal line of credit, however, is a different choice that can work better for some customers, especially those with better credit scores. Connecting a personal line of credit to an overdraft protection transfer can also be called a bounce loan. A personal line of credit is type of loan, since the bank gives you money with an interest rate and expects you to pay it back, and similar to a bank account, you draw funds from it as you need. Interest rates are often 7.25% to 20% with a nominal annual fee – for example $25 at Wells Fargo or free with one of our local credit unions, BECU (our office is in Seattle, WA).

Personal lines of credit are often a better and cheaper solution than payday loans and can help build credit by reducing credit utilization if used sparingly in emergencies. Unfortunately, this means that personal lines of credit help people who do not need credit as much as others who can’t qualify. Personal lines of credit usually require a hard credit check, and some people may not have the credit to qualify — for instance, Citibank and Wells Fargo require a credit score of 690 or higher. Oftentimes, the people who need money fast to cover important bills are the people who have the least (or no) credit, but be sure to check with your local credit union, who may extend personal lines of credit to people with bad credit (as low as 300). Getting a loan from Possible can help build credit history by offering loans that are paid off in multiple payments that are automatically deducted from your bank account painlessly on paydays over a few months. We hope that users will “graduate” to higher credit score and cheaper APR (annual percentage rate) solutions for managing their money, like personal lines of credit.

This solution is a strong compromise between expensive fees and getting money when you need it most. Most of our customers in our survey said that they use pen and paper to track their finances. This is time-consuming and error-prone, which can lead to mistakes or oversights from doing your finances too late for fees. Overdrafting from a personal line of credit will charge you less money than an overdraft fee, while giving you the safety of not bouncing checks or getting your debit card purchases declined at the mechanic with bad brakes. If you have the foresight to discover that your bank account is running low before you actually spend the money you don’t have, you can even avoid the extra $10-$12 fee altogether, since the fee is for automatically moving money from one account to another, rather than using the account.

Alternative options such as payday loans

If you don’t have enough money to make ends meet, and you don’t have to credit to qualify for a personal line of credit, you may also consider a traditional payday loan or a no credit check loan. Traditional payday loans can be very expensive, as high as 16,734,500.4% APR, but typically around 400%. They are paid in a single lump sum, usually in the next 2-4 weeks. These loans are reported differently than other loans, and sometimes require a hard credit check which can lower your credit score in the short term. A hard credit check is one that is initiated by yourself and that is made when an institution decides to make a decision about whether to lend to you, whereas soft credit checks are made for things like Credit Karma to help you monitor your credit, or pre-approved credit card offers.

Another way to get funds is through a HELOC, a home equity line of credit. Home equity lines of credit are a way to get value out of your house and into your pocket. Much like a mortgage, you offer your house as collateral, meaning that you promise that if you don’t pay, you’ll forfeit your house to cover the cost. This secured loan allows you to access the equity, or the difference between the remaining principal on your house, and the value of the house. More simply, if your house is worth $100,000 and you still have to pay $20,000 in principal (not to be confused with the total amount you still owe, principal is the remaining balance of the loan minus the interest), then you might be able to get up to $80,000 from a HELOC, depending on your lender. This is not a very realistic option for many of our customers, who are renters or don’t have a lot of home equity. But if you have this option, it can help bolster your personal checking accounts and savings accounts.

Another option is applying for a personal loan. Personal loans are “unsecured,” meaning that they do not require collateral. Other loans, like mortgages, car loans, title loans, or HELOCs, require that the bank has some asset that they can repossess in case the balance of the loan is not paid, called collateral. An asset may be something like a house, in the case of a mortgage or HELOC, or a car in the case of a car loan. This collateral makes the loan less risky for the bank, and therefore lowers the cost of the loan to the customer. Personal loans can range from 6%-36% APR and are often paid off over 2 to 5 years. These loans, however, are usually offered to customers with credit scores of 600 or higher. You’ll need to apply for credit. Using solutions like Possible can help you build your credit high enough to qualify for higher credit score and cheaper APR solutions, like personal loans. Derrick B. says about Possible that his “credit has climbed up faster than [he] ever thought it would. Went from upper 300’s to now 588-612 range and still climbing.” Experiences  like this unlock the ability for our customers to access a broader range of financial products.

Carrying a credit card balance is a choice that some customers make. Credit card APRs can run around 26% for people with bad to fair credit (between 300 and 670) but most credit card companies do not lend to anyone with a credit score under 600. In addition, you’ll likely need to be in good standing on your outstanding debt. Carrying a credit card balance increases your credit utilization ratio, which will hurt your credit. Your credit utilization ratio is the ratio of the amount of credit you have to the balance you are carrying. The higher the ratio, the closer you are to maxing out your credit cards, and will hurt your FICO® score. Using Possible Finance, however, will help to build your credit by providing an installment loan, which, when paid off on time will ideally increase your credit score.

So now what?

The financial landscape is bewildering, and can be difficult to navigate for many customers, even savvy customers who have been working with financial institutions for a long time. If you ever need to verify a specific financial institution, you can use NMLS Consumer Access to do so. Next steps for you are to go to your bank and find out if you can get a personal line of credit and turn off overdrafting altogether. If you can secure both, then you have a surefire, inexpensive way to handle unexpected expenses. And if you don’t qualify for a personal line of credit, then we would invite you to consider using Possible with a prepaid debit card to avoid overdraft and NSF fees.

Chang Fu

Chang is an avid writer, among other things, at Possible. He grew up loving reading and writing, creating his own poems and even a book he's now hidden in an old closet, unpublished. His financial experience at a large bank along with his passion for technology to help undeserved communities inspires him to write for Possible.

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