Overdraft

"I warn you, Sir! The discourtesy of this bank is beyond all limits. One word more and I — I withdraw my overdraft!"

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Cartoon from Punch Magazine Vol. 152, June 27, 1917

An overdraft occurs when withdrawals from a bank account exceed the available balance which gives the account a negative balance - a person can be said to have gone "overdrawn".

If there is a prior agreement with the account provider for an overdraft protection plan, and the amount overdrawn is within this authorised overdraft, then interest is normally charged at the agreed rate. If the balance exceeds the agreed terms, then fees may be charged and higher interest rate might apply.

History of the Overdraft

The first overdraft was awarded in 1728 when merchant William Hog was allowed to take out £1000, almost £65000 today, more than he had in his account. The overdraft was awarded by The Royal Bank of Scotland which had opened in Edinburgh the previous year. It soon began to offer interest on money paid in.

Reasons for overdrafts

Overdrafts occur for a variety of reasons. These may include:

• Intentional short-term loan - The account holder finds himself short of money within a few days of payday and knowingly makes an insufficient-funds debit. He accepts the associated fees and covers the overdraft with his next cash or check deposit. While this may be considered acceptable behaviour by the bank, it is not recommended as a financially-prudent habit.
• Personal lacking of organizational skills - The account holder does a poor job at balancing his/her checkbook or keeping good track of funds contained in the account.
• Lack of Communication - In a joint checking account, the parties do not consistently share information about checks written, withdrawals made, or check-card purchases made, leading one to believe that funds spent by the other are present.
• ATM overdraft - In recent years, many banks and ATM's often allow cash withdrawals despite insufficient funds to a limit. The account holder may or may not be aware of this fact at the time of the withdrawal. Some banks give the holder a chance to return enough cash to the account in time in order to avoid the penalty, while others do not. If the ATM is off the modem line for some reason and still functions, it may not know the account holder's available balance and allow a large overdraft. In this case, if the overdraft cannot be covered in time, the bank will sue or press criminal charges.
• Temporary Hold - Some funds in the account have been placed on hold by the bank. This may be due to Regulation CC (which governs putting holds on large dollar amount checks) or due to individual bank policies. The funds may not be immediately available and lead to overdraft fees.
• Unexpected electronic withdrawals - At some point in the past, possibly months ago, the account holder authorized electronic withdrawals by a business. If the business makes a debit without warning the accountholder, it may cause an overdraft or leave insufficient funds to cover a subsequent withdrawal or debit. This could occur in good faith of both parties if the electronic withdrawal in question is made legally possible by terms "buried" in the contract. The debit could also have been made as a result of a wage garnishment, an offset claim for a taxing agency or a credit account or overdraft with another account with the same bank, or a direct-deposit chargeback in order to recover an overpayment.
• Chargeback to merchant - A merchant could receive a chargeback because of making an unauthorized credit or debit card charge to a customer or a customer making an unauthorized credit or debit card charge to someone else's account in order to "pay" for goods or services from the merchant. It is possible for the chargeback and associated fee to cause an overdraft or leave insufficient funds to cover a subsequent withdrawal or debit from the merchant's account that received the chargeback.
• Bank reordering of transactions - The account holder makes a small debit for which there are sufficient funds in his or her account. Later, the account holder makes a large debit that overdraws the account (either accidentally or intentionally). The bank reorders the transactions and processes the large withdrawal first, resulting in multiple overdraft fee charges.
• Bank fees - The bank charges a fee unexpected to the account holder, leaving insufficient funds for a subsequent debit from the same account.
• Playing the Float - The account holder makes a debit while insufficient funds are present in the account believing s/he will be able to deposit sufficient funds before the debit clears (known as beat the bank). Many people play the float at one point or another, but this behavior is also exhibited by those committing the serious offense of check kiting. Since the advent of EFT (electronic fund transfers), playing the float has become increasingly difficult. Some banks may disable the "debit" option for ATM cards during transactions in the overdrawn status but allow transactions processed as "credit". Some other banks however consider it a "courtesy" to allow debit transactions in the overdrawn status.
• Returned check deposit - The account holder deposits a check or money order and the deposited item is returned due to NSF, a closed account, or being discovered to be counterfeit, stolen, altered, or forged. As a result of the check chargeback and associated fee, an overdraft results or a subsequent debit which was reliant on such funds causes one. This could be due to a deposited item that he knows to be bad, or he could be a victim of a bad check or a counterfeit check scam. If the resulting overdraft is too huge or cannot be covered in a short period of time, the bank could sue or even press criminal charges.
• Intentional Fraud - An ATM deposit with misrepresented funds is made or a check or money order known to be bad is deposited (see above) by the account holder, and enough money is debited before the fraud is discovered to result in an overdraft once the chargeback is made. The fraud could also be a check kiting scheme, in which the returned check could leave a huge criminal overdraft with the account that it is returned to. If the resulting overdraft is too huge or cannot be covered in a quite short period of time, the bank will sue or press criminal charges. The fraud could be perpetrated against one's own account, another person's account, or an account set up in another person's name by an identity thief. If the account belongs to another person or is in his name, it is said to be "busted out."
• Bank Error - Sometimes a bank employee misreads the handwritten amount on a check, so an amount much larger than the writer intended to write the check for will actually be removed from the account. On other occasions, a computer glitch could be responsible for an overdraft. There are also other types of bank errors which can work to the account holder's detriment, but others that could work to his initial benefit. In the latter case, the bank will correct its own error with the appropriate debit, and if a resulting overdraft cannot be covered in time, the bank could potentially sue to recover their losses caused by your unjust enrichment.
• Victimization - The account has been robbed or cleaned out by a thief. This could occur as the result of demand-draft, ATM-card, or debit-card fraud, theft associated with a rigged ATM machine, check forgery, an "account takeover," or phishing. The criminal act could cause an overdraft or cause a subsequent debit to cause one. The money or checks from an ATM deposit could also have been stolen or the envelope lost or stolen, in which case the victim is often denied a remedy.
• Daylight overdraft - A debit balance in the customer’s account that occurs in the course of the business day and is expected to be repaid by a credit to the account prior to the end of the banking day. Whether this actually results in an overdraft and the resultant fees depends on the deposit-account holder agreement with the bank. This may be considered an example of playing the float, but if the deposit is made available by the bank before the ledger is balanced at the end of the business day and the balance remains positive at that time, technically no overdraft occurs.

Overdraft protection in the United Kingdom

Main article: unauthorised overdraft fee

Banks in the UK often offer a basic overdraft facility, subject to a pre-arranged limit (known as an authorised overdraft limit). However, whether this is offered free of interest, subject to an average monthly balance figure or at the bank's overdraft lending rate varies from bank to bank and may differ according to the account product held.

When a customer exceeds their authorised overdraft limit, they go into unauthorised overdraft which often results in the customer being charged one or more fees, together with a higher rate of lending on the amount by which they have exceeded their authorised overdraft limit. The fees charged by banks can vary.

A customer may also incur a fee if they present an item which their issuing bank declines for reason of insufficient funds, that is, the bank elects not to permit the customer to go into unauthorised overdraft. Again, the level and nature of such fees varies widely between banks.

In 2006 the Office of Fair Trading issued a statement which concluded that credit card issuers were levying penalty charges when customers exceeded their maximum spend limit and / or made late payments to their accounts. In the statement, the OFT recommended that credit card issuers set such fees at a maximum of 12 UK pounds [1].

In the statement, the OFT opined that the fees charged by credit card issuers were analogous to unauthorised overdraft fees charged by banks. Many customers who have incurred unauthorised overdraft fees have used this statement as a springboard to sue their banks in order to recover the fees. It is currently thought that the England and Wales county courts are flooded with such claims [2]. Claimants tend frequently to be assisted by web sites such as The Consumer Forums which includes The Consumer Action Group. To date, many banks do not appear in court to justify their unauthorised overdraft charging structures and many customers have recovered such charges in full [3]. However, there have been cases where the courts have ruled in favour of the banks and alternatively struck out claims against customers who have not adequately made a case against their bank(see BBC article).

In response to claims by customers to recover their charges, some banks have closed customer accounts, on the basis that those accounts have not been operated within the terms and conditions [4] which the customer consented to when the account was opened.

Overdraft protection in the United States

Overdraft protection is a financial service offered by banking institutions primarily in the United States. Overdraft or courtesy pay program protection pays items presented to a customer's account when sufficient funds are not present to cover the amount of the withdrawal. Overdraft protection can cover ATM withdrawals, purchases made with a debit card, electronic transfers, and checks. In the case of non-preauthorized items such as checks, or ACH withdrawals, overdraft protection allows for these items to be paid as opposed to being returned unpaid, or bouncing. However, ATM withdrawals and purchases made with a debit or check card are considered preauthorized and must be paid by the bank when presented, even if this causes an overdraft.

Ad-hoc coverage of overdrafts

Traditionally, the manager of a bank would look at the bank's list of overdrafts each day. If the manager saw that a favored customer had incurred an overdraft, he had the discretion to pay the overdraft for the customer. Banks traditionally did not charge for this ad-hoc coverage. However, it was fully discretionary, and so could not be depended on. With the advent of large-scale interstate branch banking, traditional ad-hoc coverage has practically disappeared.

Many banks do now have overdraft departments which examine overdrawn accounts and decide whether to pay or return checks and whether or not to charge overdraft fees. The process is largely automated, but the department also examines individual accounts on a case-by-case basis.

Overdraft lines of credit

This form of overdraft protection is a contractual relationship in which the bank promises to pay overdrafts up to a certain dollar limit. A consumer who wants an overdraft line of credit must complete and sign an application, after which the bank checks the consumer's credit and approves or denies the application. Overdraft lines of credit are loans and must comply with the Truth in Lending Act. As with linked accounts, banks typically charge a nominal fee per overdraft, and also charge interest on the outstanding balance. Some banks charge a small monthly fee regardless of whether the line of credit is used. This form of overdraft protection is available to consumers who meet the creditworthiness criteria established by the bank for such accounts. Once the line of credit is established, the available credit may be visible as part of the customer's available balance.

Linked accounts

Also referred to as "Overdraft Transfer Protection", a checking account can be linked to another account, such as a savings account, or to an existing line of credit such as a credit card or home equity line of credit. Once the link is established, when an item is presented to the account that would result in an overdraft, funds are transferred from the linked savings account or linked credit account to cover the overdraft. A nominal fee is usually charged for each overdraft transfer, and if the linked account is a credit card or other line of credit, the consumer may be required to pay interest under the terms of that account.

The main difference between linked accounts and an overdraft line of credit is that an overdraft line of credit is typically only usable for overdraft protection. Separate accounts that are linked for overdraft protection are independent accounts in their own right; a line of credit is linked solely to the checking account. Although it is possible to transfer funds from an overdraft line of credit, it typically requires you to overdraw your account.

Bounce protection plans

A more recent product being offered by some banks is called "bounce protection."

Smaller banks offer plans administered by third party companies which help the banks gain additional fee income. Larger banks run similar plans, which they usually disclose in their account opening terms.

Under the plans, the bank may choose to cover overdrawn items at their discretion and charge an overdraft fee, the amount of which may or may not be disclosed. As opposed to traditional ad-hoc coverage, this decision to pay or not pay overdrawn items is automated and based on objective criteria such as the customer's average balance, the overdraft history of the account, the number of accounts the customer holds with the bank, and the length of time those accounts have been open. However, the bank does not promise to pay the overdraft even if the automated criteria are met.

These plans have some superficial similarities to overdraft lines of credit and ad-hoc coverage of overdrafts, but tend to operate under different rules. Like an overdraft line of credit, the balance of the bounce protection plan may be viewable as part of the customer's available balance, yet the bank reserves the right to refuse payment of an overdrawn item, as with traditional ad-hoc coverage. Banks typically charge a one-time fee for each overdraft paid. A bank may also charge a recurring daily fee for each day during which the account has a negative balance.

Critics argue that because funds are advanced to a consumer and repayment is expected, that bounce protection is a type of loan. Because banks are not contractually obligated to cover the overdrafts, "bounce protection" is not regulated by the Truth in Lending Act, which prohibits certain deceptive advertisements and requires disclosure of the terms of loans. Bounce protection can be added to a consumer's account without his or her permission, and without informing the consumer.

In May 2005, Regulation DD of the Truth in Savings Act was amended to require that banks offering "bounce protection" plans provide certain disclosures to their customers. These amendments include requirements to disclose the types of transaction that may cause bounce protection to be triggered, the fees associated with bounce protection, separate statement categories to enumerate the number of fees charged, and restrictions on the marketing of bounce protection programs to deter misleading advertisements.

Costs

As a source of revenue, banks have the option of charging a fee for every use. Fees vary widely depending on the bank and on the kind of overdraft protection used.

Banks process all transactions in the same manner, so customers can incur these fees even with ATM or debit card transactions. Compounding the issue, a bank may authorize transactions in such a way that a single purchase, made with available funds, can trigger multiple overdraft fees.

Banks collected $17.5 billion in overdraft fees in 2006; up from $10.3 billion in 2004.

Transaction processing order

Most US banks use a "biggest check first" posting order, by which items posting to a customer's account post according to the amount of the item, as opposed to the transaction date. The "biggest check first" policy is common among large U.S. banks, such as Bank of America, JP Morgan Chase, Citibank, Wells Fargo and Wachovia. Banks argue that this is done to prevent a customer's most important transactions (such as a rent or mortgage check, or utility payment) from being returned unpaid. This also has the effect of maximizing fee income since the larger items deplete the account balance causing multiple overdrafts by smaller items that present on the same day. Consumers have attempted to litigate to prevent this practice, arguing that banks use "biggest check first" to manipulate the order of transactions to artificially trigger more overdraft fees to collect.

Here is an example of how processing order affects overdraft costs: A customer has $100 in her account. She has an outstanding check for $80.00. She buys a cup of coffee for $1.79 in the morning, buys a $7.00 lunch, and goes to the movies with a friend, spending another $25. If she checks her balance, it would show a balance of $66.21 (100-33.79). However, that night, her check clears, leaving her with a balance of -13.79. With the highest to lowest processing order, the $80 check would clear without incurring an overdraft fee, but the remaining 3 transactions would each incur a fee. Bank representatives claim that the 'biggest check first' processing order benefits customers as larger transactions (such as mortgage or car payments, etc) usually have larger consequences if they bounce (higher interest rates, default fees, etc). Bank deposit agreements usually provide that the bank may clear transactions in any order, at the bank's discretion.

'Biggest check first' is not a universal banking concept. Although most larger banks do process from the highest dollar amount, many smaller banks and credit unions will process transactions as they come in.

Benefits and risks

If corrected in a timely manner, the costs of overdraft protection are typically lower than the fines incurred for bouncing a check. For a bounced check, the bank will charge the customer a nonsufficient funds fee (NSF) and the cashing institution will charge a returned check fee, sometimes in addition to the amount of the check. This package of fines may be dramatically higher than the single overdraft protection fee.

For checks, overdraft protection also prevents the cashing institution from knowing that the person is low on cash which can serve to protect the customer's reputation.

If the overdrawn state is not corrected within a short period of time, however, the costs of overdraft protection increase. If using an overdraft line of credit which isn't paid back, the interest can accumulate, and in severe cases the line of credit can be charged off and reported to credit reporting agencies. A similar scenario can also occur if the bank charges a daily fee for having an overdrawn account.

The costs of overdraft protection are typically far higher than the costs of attempting make a purchase with a debit card or make an ATM withdrawal from an account with insufficient funds. In the absence of overdraft protection, such ATM withdrawals and debit purchases may be refused without a fee. The consumer then may choose to cancel the transaction or to borrow money from a less-expensive source.

If a US bank account is left overdrawn, after a minimum number of business days that the account remains overdrawn, a fee may be assessed for every additional business day that the account remains overdrawn. Before long, the bank will close the account unless it is satisfied that the debt is being paid off in a good-faith manner, refer it for collection, and have its handling as a negative record against its holder on credit reports and with ChexSystems. Reporting of a US account closed due to an overdraft not paid in time may prevent the opening of an account with another US bank for five years.

Proposed legislation

H.R. 946, introduced in the US Congress on February 8, 2007, would increase regulation of overdraft loan programs. The proposed legislation would Amend the Truth in Lending Act (Regulation Z) to clarify that overdraft fees are covered, require written consent before enrollment in the overdraft loan program, require financial institutions to warn the customer when an ATM withdrawal will trigger a fee, and prohibit financial institutions from changing the order of check clearing or delaying the posting of deposits solely to increase overdraft fees.

See also

• Authorization hold
• Banks
• Building societies
• Credit
• Current accounts
• Unauthorised overdraft fee