What is Overdraft Interest & How to Prevent It

What is Overdraft Interest?

Overdraft interest are charges on funds you borrow to cover a payment or withdrawal because of insufficient funds in your bank account. 

These interest charges arise if your account has overdraft protection, meaning your bank will automatically extend credit to you in the event a transaction causes your balance to go negative.

Paying overdraft interest isn’t necessarily a bad thing, as it stems from money loaned to you when you’ve exhausted your available balance.

Having access to this type of short term credit can be valuable, particularly during a financial emergency.

Still, if you’re already saddled with numerous debt payments, adding yet another debt with more interest charges isn’t ideal.

Typical overdraft interest rates range from 19% to 22%, so it’s wise to use overdrafts sparingly.

How Does Overdraft Work?

Suppose you don’t have enough funds in your bank account to cover a transaction.

Ordinarily, the transaction would fail, but with an overdraft in place, it would process successfully, as though you had sufficient funds to cover it.

Your account balance would go into the negative because of the overdraft.

Here’s an example to illustrate what would occur if your account didn’t allow overdrafts:

You owe a friend $500 and decide to write them a cheque for this amount.

You currently only have $100 in your bank account.

Yhe cheque will bounce when they try to cash it.

As a result, their financial institution will refuse the payment and charge you a non-sufficient funds (NSF) fee.

How is Interest Calculated on an Overdraft?

When your bank account goes into overdraft, interest begins accruing immediately – there’s no grace period

Your financial institution will charge interest each day based on the ending overdraft balance in your account.

For example, let’s assume you overdraw your account by $150 for eight days at a 21% annual rate.

In that case, you’ll incur $0.69 in interest charges.

Here’s a breakdown of the calculation: balance owing ($150) x annual interest rate (0.21) / number of days in a year (365) x number of days in overdraft (8) = $0.69

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How Can I Prevent Overdraft Fees?

In addition to interest charges, you’ll get hit with fees if you overdraw your bank account.

The best way to avoid fees is to monitor your spending continuously and diligently to ensure your account rarely, if ever, goes into the negative.

Consider always keeping a little extra money in your account over and above your typical monthly spending budget as a buffer.

You might want to set up an alert to warn you when your balance hits a certain threshold. 

You can also minimize your fees by going with a pay-per-use overdraft plan instead of a flat rate.

What is Overdraft Protection and How Does it Work?

Overdraft protection is a type of credit facility offered by financial institutions to cover payments and withdrawals originating from accounts with an insufficient balance. 

With overdraft protection, you can make point-of-sale purchases, withdraw cash from an ATM, transfer funds, arrange pre-authorized debits, and write cheques.

You’ll have peace of mind knowing these transactions are guaranteed to process should you overcharge your account.

Of course, this doesn’t grant you the freedom to spend as you please – there’s a limit to how much overdraft protection your bank will provide to you.

And you’ll be responsible for paying the applicable interest and fees each time you utilize this privilege.

Is Overdraft Protection Worth It?

Overdraft protection is worth having only if you plan to use it in emergencies where you’re running low on cash.

Generally, it doesn’t hurt to have overdraft protection as a backup plan.

If you meticulously watch your budget, the risk of your account going into the negative is rare, and therefore you won’t rack up overwhelming overdraft interest fees. 

If you anticipate using overdraft protection routinely, be aware that you risk paying steep fees and accumulating burdensome interest charges.

Getting your finances in good order might be a better option to pursue, especially if you’re already heavily in debt.

Pros of Overdraft Protection

  • Your transaction will get processed: if you need to make an emergency withdrawal or pay a critical bill, the transaction is guaranteed to get processed (up to your overdraft limit of course).
  • You’ll avoid NSF fees and late payment charges: you won’t incur fees resulting from declined transactions. NSF fees can be as high as $50.
  • It’s cheaper than many high-interest credit products: despite charging rates on par with those found on credit cards, overdraft protection coverage is still more affordable than high-interest debt products like payday loans, where rates can climb as high as 500%!

Cons of Overdraft Protection

  • You’ll pay fees: you may have to pay a fee every time you overdraw your account, which can add up over time and strain your budget. 
  • You might be tempted to overspend: overdraft protection may encourage reckless spending. You could easily find yourself extended beyond your means and in a tighter spot financially, especially since overdraft loans charge high-interest rates. 

Don’t Forget!

If you fail to settle your overdraft balance by the deadline stated in your agreement, your bank will consider your account to be in default, which can harm your credit score.

Frequently Asked Questions

  • Is overdraft interest paid monthly?
  • How can I avoid paying interest on overdraft?
  • How do you pay back an overdraft?

Mark is a freelance writer who specializes in writing content for firms in the financial services industry, including fintech. He has written for brands like Loans Canada, LowestRates, and The Motley Fool, covering topics related to investing, mortgages, credit cards, and many others.

He is passionate about educating people on how the financial markets work and providing tips to help them better manage their money. Mark holds a bachelor’s degree in finance from the Northern Alberta Institute of Technology and has more than a decade of experience as an accountant.

Outside of writing and finance, he enjoys playing poker, going to the gym, composing music, and learning about digital marketing.