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 known 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.
Reasons for overdrafts
Overdrafts occur for a variety of reasons. These may include:
- Intentional short-term loan - The account holder finds themselves short of money within a few days of payday and knowingly makes an insufficient-funds debit. They accept the associated fees and covers the overdraft with their next cash or check deposit.
- Failure to maintain an accurate account register - The account holder does a poor job at balancing their checkbook resulting in the customer overspending their available balance.
- 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 - Banks or ATMs may allow cash withdrawals despite insufficient availability of funds. 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 unable to authorize a withdrawal from the cardholder's bank, it may automatically authorize a withdrawal based on limits preset by the authorizing network.
- Temporary Hold - Some funds in the account have been placed on hold by the bank. This may be due to Regulation CC (which governs the placement of holds on deposited 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 the account holder may have authorized electronic withdrawals by a business. If the business makes a debit without warning the account holder, 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 of the contract, such as the initiation of a recurring service following a free trial period. 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.
- Merchant error - A merchant may improperly debit a customer's account due to human error. For example, a customer may authorize a $5.00 purchase which may post to the account for $500. The customer has the option to recover these funds through chargeback to the merchant.
- Chargeback to merchant - A merchant could receive a chargeback because of making an improper 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.
- Authorization holds - When a customer makes a purchase using their debit card without using their PIN, the transaction is treated as a credit transaction. The funds are placed on hold in the customer's account reducing the customer's available balance. However the merchant doesn't receive the funds until they process the transaction batch for the period during which the customer's purchase was made. Banks do not hold these funds indefinitely, and so the bank may release the hold before the merchant collects the funds thus making these funds available again. If the customer spends these funds, then barring an interim deposit the account will overdraw when the merchant collects for the original purchase.
- 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 they will be able to deposit sufficient funds before the debit clears. While many cases of playing the float are done with honest intentions, the time involved in checks clearing and the difference in the processing of debits and credits are exploited by those committing check kiting.
- Returned check deposit - The account holder deposits a check or money order and the deposited item is returned due to non-sufficient funds, 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 is known to be bad, or the customer could be a victim of a bad check or a counterfeit check scam. If the resulting overdraft is too large 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 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.
- Bank Error - 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 error 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 their benefit.
- Victimization - The account has been robbed by a thief. This could occur as the result of demand-draft, ATM-card, or debit-card fraud, skimming, 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.
- Intraday overdraft - A debit occurs in the customer’s account resulting in an overdraft which is then covered by a credit that posts to the account during the same business day. Whether this actually results in overdraft fees depends on the deposit-account holder agreement of the particular bank.
Overdraft protection in the United Kingdom
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. Barclays have a 'no-charge' limit of £5 into your overdraft, any further into your overdraft and charges occur. HSBC also operate this scheme except their limit is £10.
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 .
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 . 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 . 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.
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 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, they 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.
Also referred to as "Overdraft Transfer Protection", a checking account can be linked to another account, such as a savings account, credit card, or line of credit. Once the link is established, when an item is presented to the checking account that would result in an overdraft, funds are transferred from the linked 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.
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 tend not to offer bounce protection plans, but instead process overdrafts as disclosed in their account terms and conditions.
In either case, 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.
Bounce protection 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. Historically, bounce protection could be added to a consumer's account without his or her permission or knowledge.
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. These disclosures are already provided by larger banks which process overdrafts according to their terms and conditions.
US Banks collected $12 billion in overdraft fees in 2007.
Transaction processing order
An area of controversy with regards to overdraft fees is the order in which a bank posts transactions to a customer's account. This is controversial because largest to smallest processing tends to maximize overdraft occurrences on a customer's account. This situation can arise when the account holder makes a number of small debits for which there are sufficient funds in the account at the time of purchase. Later, the account holder makes a large debit that overdraws the account (either accidentally or intentionally). If all of the items present for payment to the account on the same day, and the bank processes the largest transaction first, multiple overdrafts can result.
The "biggest check first" policy is common among large U.S. banks. 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. 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, but to date the practice has not been found to be illegal.
Bank deposit agreements usually provide that the bank may clear transactions in any order, at the bank's discretion.
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 receiving institution from knowing that the customer's account is overdrawn 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.
If an account is left overdrawn, the issuing bank will close the account unless other payment arragements are in place. They may refer it for collection and report it as a negative record with ChexSystems which may prevent the opening of an account with many banks for five years.
H.R. 946, introduced in the US House of Representatives 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. This bill was referred to committee in April 2007 and is expected to die in committee.