An overdraft line of credit is a pre-approved loan attached to your checking account. If you don’t have enough money in your account to cover a transaction (such as a debit card transaction or automatic bill payment), the line of credit kicks in and covers the overdraft. This prevents denied and failed transactions, overdraft fees, non-sufficient fund fees, and potentially other fees and headaches. However, these credit lines come with costs of their own. Are they worth it? Here are key things to know about overdraft protection lines of credit.
What Is an Overdraft Line of Credit?
An overdraft line of credit is a feature offered by banks and credit unions that links your checking account to an established line of credit. If you sign up for this type of overdraft protection, you can borrow against that line of credit to cover shortfalls when (or if) you overdraw your checking account.
For example, let’s say your checking account is low on cash due to some unexpected expenses, then an automated payment goes through or a check you wrote a while ago (and forgot about) gets cashed. With an overdraft line of credit, the bank or credit union will cover that overage by drawing from your credit line. The payments will go through and you won’t get hit with a non-sufficient funds (NSF) or bounced check fee.
However, there are still costs involved. Credit unions and banks that offer an overdraft line of credit will typically charge a transfer fee each time you draw from the credit line. On top of that, you’ll pay interest on the borrowed balance until you pay it off.
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How Overdraft Lines of Credit Work
Typically, if your checking account doesn’t have enough money to cover a debit card purchase, check, or online bill payment, the bank will either cover the pending transaction and charge you overdraft fee, or they will reject the transaction and charge you a fee for insufficient funds (you may also get hit with a fee from the party that was expecting payment).
If you have a checking account with an overdraft line of credit, on the other hand, any overdraft is automatically withdrawn from your line of credit and deposited into your account. You will typically be charged a small fee for each overdraft that is covered. You’ll also pay interest on the money you borrow from your credit line.
An overdraft protection line of credit has a preset amount it can cover on your behalf, which can range from $500 to $7500 or more. As with other lines of credit, you only pay a transfer fee or interest if you actually borrow money from the credit line.
Banks and credit unions often have requirements for customers to qualify for an overdraft line of credit, such as maintaining a specific account balance for a certain period of time, depositing money regularly into the account, having a positive credit history, and having minimal overdrafts in your recent banking history.
What Happens if You Use Your Overdraft Line of Credit?
If you use your overdraft line of credit, the bank or credit union will typically charge a transfer fee and interest on the balance provided for your purchase. For example, say you spend $100 at the grocery store using your debit card but only have $60 in your account. The transaction will go through and your overdraft line of protection kicks in, putting $40 in your account.
You’ll pay a small fee for the cash transfer (usually around $12) and the $40 balance will start accruing interest until it’s paid back in full. You’ll need to repay the amount you borrowed according to the terms set by your bank. Typically, you need to make monthly payments, either manually or by having them automatically deducted from your checking account.
Keep in mind that once you use an overdraft line of credit, it can have an impact on your credit, since it qualifies as a loan. Paying off the balance in a timely fashion can have a positive impact on your credit, while carrying a high balance and/or making late payments can have a negative impact on your credit.
Recommended: Can You Overdraft a Credit Card?
Pros and Cons of Overdraft Lines of Credit
An overdraft line of credit can save you in a pinch but can also cause unwanted financial consequences. Here are some benefits and potential pitfalls to consider.
Pros of Overdraft Lines of Credit
• Provides a safety net. Overdraft credit lines (which often come with high limits) can help you afford necessary expenses and handle emergencies without taking out a loan.
• Transactions won’t fail. With an overdraft line of credit, debit card purchases, online bill payments, and checks will go through successfully, even if you don’t have the funds in your account to cover them.
• May be cheaper than other options. The transfer fee plus the interest charges can end up costing less than overdraft fees and the penalties for returned payments and checks.
• Can help you build credit. Drawing from your credit line and then paying off your balance responsibly can have a positive impact on your credit.
Cons of Overdraft Lines of Credit
• Not everyone qualifies. Approval for the line of credit may involve passing lender requirements, such as keeping a certain average account balance, signing up for direct deposit, and having a strong credit history.
• Fees can add up. Typically, you incur a transfer fee for every advance. Some lenders also charge annual fees and account fees for overdraft lines of credit.
• Interest rates tend to be high. Overdraft lines of credit tend to have high interest rates because there’s no collateral from the borrower, which increases risk to the lender.
• Could negatively impact your credit. If you carry a high balance and/or don’t make your payments on time, an overdraft credit line could have a negative impact on your credit.
Alternatives to Overdraft Lines of Credit
While overdraft lines of credit offer convenience and might help you save money, other options might be more beneficial depending on your situation. Here’s a breakdown of the alternatives to overdraft lines of credit.
Effective Account Management
Effectively managing your checking account and finances can help you avoid overdrafts altogether. This entails regularly monitoring your account balance, signing up for “low balance” alerts, and always keeping a cushion of cash in your checking account.
Link Another Account to Your Checking Account
Linking your checking account to another financial account, such as a savings account, can provide a safety net in case of insufficient funds. If a transaction will overdraft your checking account, funds will automatically transfer from the linked account to cover the shortfall.
This option avoids overdraft fees and ensures that your transactions are not declined due to insufficient funds. However, you may pay a transfer fee when the protection is triggered, and you’ll need sufficient funds in your linked deposit account to cover the overdrawn amount to use this service.
Opt Out of Overdraft Coverage
If all of your bank’s overdraft protection options involve costs, you might consider going without overdraft coverage. If you go this route, your bank will decline any transactions that would bring your account into the negative. This could put you in a difficult situation if you can’t make a needed purchase, but you’ll avoid overdraft fees and/or running up interest.
Consider Switching Banks
You may be able to find a bank with generous overdraft protections for checking accounts. For example, some banks offer grace periods after overdrafts, such as one business day to cover the overage without incurring any penalties. In addition, many financial institutions have reduced or eliminated their overdraft fees.
Recommended: Switching Bank Accounts When in Overdraft
The Takeaway
Overdraft lines of credit give bank and credit union customers immediate access to funds to cover transactions and avoid costly overdraft and non-sufficient fund fees.
While they can cover emergency expenses and prevent transactions from failing when your account balance is low, high interest rates and credit implications can lead to other challenges. Alternatives to using an overdraft line of credit include: effective account management, linking accounts, and/or finding a bank with favorable overdraft policies.
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FAQ
Does tapping into your overdraft line of credit affect your credit score?
Tapping into your overdraft line of credit means taking on debt, which can impact your credit. If you consistently make timely payments and manage that debt responsibly, it can have a positive impact on your credit history. Conversely, if you fail to repay the borrowed amount on time, it could lead to negative marks on your credit report.
How does an overdraft protection line of credit work?
An overdraft line of credit is a safety net for checking accounts, providing funds to cover transactions that exceed available balances. When faced with insufficient funds, the bank or credit union extends a predetermined line of credit, allowing the transaction to proceed without incurring overdraft fees. The customer then repays the borrowed amount, along with any applicable fees and interest.
Can you overdraw your credit limit?
No, you cannot overdraw beyond the credit limit set for your overdraft line of credit. Your bank establishes a maximum limit based on your creditworthiness and financial history. If a transaction exceeds this limit, it will typically be declined, and you may still face fees for insufficient funds. It’s important to be aware of your credit limit and monitor your account to avoid transactions that might exceed it.
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