Should You Opt-In or Opt-Out of Overdraft Protection?

When you open a checking account in the United States, by law, the bank is required to ask you if you want to opt-in or opt-out of overdraft protection.

While having "protection" of any sort typically sounds appealing, you need to understand what opting-in to overdraft protection actually means.

When you opt-in to overdraft protection, this means that if you make a charge to your account for more than your account balance, the charge will go through, your balance will become negative, and you're going to get charged an overdraft fee (which is typically around $40 depending on the bank you have). Not only that, while your account is overdrawn, for every additional charge that goes in you will be charged an additional overdraft fee.

Consider the following example: You’re a college student with $100 in your checking account. You haven’t checked your balance in a couple days and you think you have $200 in your account. You purchase a textbook for $150. If your account has overdraft protection, your charge will go through, your account balance will become negative, and you’ll get charged an overdraft fee. So now your account balance is:

Now let’s say after you purchase the textbook, you decide to buy lunch for $10. Later, you have a meeting with your professor so you buy a $2 pack of gum to freshen up before the meeting. When you bought lunch, because your account balance was negative, you’re going to get an additional overdraft charge (another $40) and an additional overdraft charge when you bought gum.

The next time you check your account balance, you will expect to see: $200 (what you thought your balance was) - $150 (for the textbook) - $10 (lunch) - $2 (pack of gum) = $38.

Instead, your actual balance is: $100 (Starting balance) - $150 (textbook) - $40 (textbook overdraft fee) - $10 (lunch) - $40 (lunch overdraft fee) - $2 (back of gum) - $40 (gum overdraft fee) = -$182 !!!

A rather unpleasant surprise indeed!

This could have all been avoided if you had simply opted-out of overdraft protection. Without overdraft “protection”, when you tried to purchase the textbook, the charge would have simply not gone through. In which case, you’d have to wait till your next paycheck to buy the book, and you would have still been able to eat your lunch and buy your gum without incurring any fees.

Some banks allow you to link your savings account to your checking account so that when your checking is overdrawn, the bank will automatically transfer money from your savings to your checking to cover the difference. This is a good option if you maintain a healthy balance in your savings account but doesn’t do much good for someone who doesn’t maintain much in their savings anyway. When you link your checking with your savings, if there isn’t enough in your savings to cover the overdraft, the bank will just put your balance in the negative, charge you an overdraft fee and your back in the situation I described earlier.

The corollary to opting out of overdraft protection is that you need to be extra careful when writing checks. There are few financial sins that are more egregious and financially harmful than writing a check that bounces. So, when you're writing checks, make sure you are extra careful to check your balance and take into account all the future charges that could go through between now and when your check is cashed making sure that your balance can cover all these charges.

If you do write checks frequently, then it may make sense to keep your overdraft protection. However, writing physical checks has become less and less common and there are increasingly better substitutes for you to choose from.  

So, in general, I always advise people to opt-out of overdraft protection. This is especially applicable for people who only carry a few hundred dollars in their accounts, are at a greater risk of overcharging their accounts, and can’t make any mistakes with their finances.