Does Overdraft Protection Affect Credit Score?

Consumer bank accounts can dip into a negative balance for a number of reasons, but one of the biggest is the assessment of overdraft fees. Whether due to simple mathematical mistakes, delays in anticipated deposits and other credits, or administrative bank errors, a checking account can become overdrawn and fall into that negative balance status before you know it. Once that happens, it’s important to remedy the situation and bring the account balance to zero or above as quickly as possible. Otherwise, you will start piling on overdraft fees.

Overdraft fees are big business for banks and financial institutions that serve consumers. What’s more, for at least six U.S. banks, the revenues they gained from overdraft fees accounted for over 50% of their annual net income.^[1] According to the Consumer Financial Protection Bureau, overdraft fees can make banking and traditional checking accounts too expensive for many people.^[2]

If your financial institution offers such a program, should you enlist in it? More crucially, will using overdraft protection affect your credit score?

What are overdraft fees?

If you write your landlord a check for November rent in the amount of $1,000, the landlord would then take the physical check and deposit it into their account at their bank, which would present the check to your bank for processing. What happens if you only have $900 in your account?

That’s where overdraft fees can come into play and create a real financial bind. Your bank can do one of two things:

1. Cover the shortage—the overdraft—and transfer the funds to the landlord’s bank; or
2. Decline to cover the overdraft and return the check to your landlord’s bank, meaning you still owe November’s rent, as well as additional fees from both the landlord as well as your own bank.

When your bank chooses the first option, it will probably assess an overdraft fee against your account to reimburse it for additional administrative costs. If it decides to decline coverage, it will probably assess a different kind of fee called a non-sufficient funds or NSF fee.

Are overdraft fees the same as non-sufficient funds (NSF) fees?

Although most banks typically establish both overdraft and NSF fee rates at the same amount, they’re not the same. The key difference between the two is that overdraft fees arise in a situation where the underlying transaction is honored, even though that results in your account dipping into a negative balance, whereas NSF fees represent the situation where the transaction itself is also declined.

Depending on your starting account balance, you can wind up with a negative balance in either case, but when NSF fees are assessed, you’ll also still owe the amount of the original transaction. So while the two fees are not identical, they can both have similar negative impacts on your finances and bank account.

How does overdraft protection work?

Banks and credit unions offer overdraft protection programs as a way to ensure your financial obligations are met and recover their costs while also helping prevent overdraft fees from draining your account. They’re generally packaged as either an included or add-on service for checking account customers, up to a specified dollar amount. In some cases overdraft protection will cost a flat rate or a fee based on a percentage of the transaction, while some banks offer the service free of charge.

Overdraft protection programs generally work by linking up a secondary account, such as a savings account, to the customer’s primary checking account. That secondary account must also carry a sufficient balance to cover any potential overdrafts.

For example, if a third party presents a checking or debit card transaction that would send the primary checking account into an overdraft situation with a negative balance, the bank can simply transfer funds from a secondary account to prevent that from occurring. Without overdraft protection, the transaction may be declined altogether, incurring an NSF fee as well as additional fees from the third party and their bank.

How high are overdraft fees usually?

For most banks, overdraft and NSF fees (which are typically established in the same amount, or nearly so) range from $30 to $35.^[3] Some banks set higher fees, while some other types of financial institutions—primarily credit unions—set their fees at lower amounts.

Banks and other financial institutions generally set their overdraft and NSF fees by policy. While some states may adopt statutes that limit the amount of such fees, federal laws do not provide any upper limit on overdraft fees.^[4] However, the Consumer Finance Protection Bureau has announced its intention to seek regulatory means of redress for consumers overburdened by the banking industry’s reliance on these fees as a profit center.^[5]

Is it bad to use overdraft protection?

All things being equal, the best outcome is to never let your checking account get so close to zero that you risk overdrawing it and incurring fees. However, surprises and mistakes do happen, even to the most careful account holders.

For that reason, it’s far better to sign up for an overdraft protection program than to incur an overdraft fee or, worse yet, an NSF fee. Overdraft protection also helps keep your bank from closing your overdrawn checking account and sending the debt to collections. If that happens, you may find a host of adverse consequences that present significant challenges to achieving financial goals in the future.

Can using your overdraft protection hurt your credit score?

There are currently three major credit reporting agencies or bureaus in the U.S., in addition to several smaller, more targeted or niched credit reporting companies.^[6] The data these agencies collect and disseminate will, in large part, determine your credit rating or score. Overdrafts are not reported as debts in collections or arrears to these three main agencies, and consequently an overdraft will not directly impact your credit score.

However, an overdrawn checking account that isn’t brought back into good standing can damage your credit history and rating indirectly. Your bank or credit union may close your checking account and turn the negative balance over to a collections company. At that point, the negative balance is considered a consumer debt that is reportable to the three agencies and your credit could be adversely impacted, especially if the debt is turned over to a debt collection agency. The consequences may be a lower credit score. Depending on your exact score, you might find it difficult to qualify for a new job, or apartment. Your bank or credit union may also report your account to CheckSystems ® which could hurt your chances of opening a future account.

Using overdraft protection won’t hurt your credit score unless you fail to repay the underlying debt, including the overdraft and any assessed fees. It’s far preferable to incurring the fees, which can create a cascading sequence of negative financial consequences.

How do you avoid overdraft fees?

To avoid overdraft fees, adopt a few healthy financial and bank account management habits:

• Know how much money you have in your account and keep it balanced;
• Add $50 to $100 or so to your checking account as a buffer against overdrafts and resolve not to spend it down;
• Pay cash for as many expenditures as possible;
• Enroll in direct deposit with your employer, as this can help prevent delays in deposits being posted and credited to your account.

Overdraft protection is a great way to help protect against nasty surprises. Together with these four strategies, you might be able to avoid those surprises altogether.

Tips to avoid using your overdraft protection

Despite the clear benefits of overdraft protection, it’s not a service you want to use too often.

If you do use overdraft protection, you can ask your bank to refund overdraft fees that have already been or are about to be assessed. This is especially helpful if you realize you’re about to be overdrawn, but the transaction hasn't been posted yet. If you have a relatively clean account track record without a slew of overdraft and NSF fees, your bank may refund the current fee as a one-time courtesy.

It probably won’t work more than once or twice, so don’t depend on this strategy for future overdrafts, but it can help remedy a first-time error and put that money back in your account.

Sources

1. Aaron Klein, “A few small banks have become overdraft giants,” https://www.brookings.edu/opinions/a-few-small-banks-have-become-overdraft-giants/, Brookings Institution, 3/1/2021 (accessed July 24, 2022)

2. CFPB, “Overdraft fees can price people out of banking” https://www.consumerfinance.gov/about-us/blog/overdraft-fees-can-price-people-out-of-banking/ (accessed July 24, 2022)

3. FDIC, “Your Guide to Preventing and Managing Overdraft Fees,” https://www.fdic.gov/consumers/overdraft/overdraft-hi-rez.pdf (accessed July 24, 2022)

4. Office of the Comptroller of the Currency, “The bank charged a fee for an overdraft, and the amount seems excessive. Is there a limit?” https://www.helpwithmybank.gov/help-topics/bank-accounts/nsf-fees-overdraft-protection/overdraft-protection-programs/overdraft-fee-excessive.html (accessed July 25, 2022)

5. Consumer Finance Protection Bureau, “Prepared Remarks of CFPB Director Rohit Chopra on the Overdraft Press Call,” December 1, 2021 https://www.consumerfinance.gov/about-us/newsroom/prepared-remarks-cfpb-director-rohit-chopra-overdraft-press-call/ (accessed July 25, 2022)

6. CFPB, “List of Consumer Reporting Companies,” 2020 https://files.consumerfinance.gov/f/documents/cfpb_consumer-reporting-companies-list.pdf (accessed July 25, 2022)

About the author

John Boitnott is a longtime digital media consultant and journalist who covers technology trends, startups, entrepreneurship and personal finance for Inc, Entrepreneur, Business Insider, USA Today and other major publications.

About the reviewer

Ana Gonzalez-Ribeiro, MBA, AFC® is an Accredited Financial Counselor® and a Bilingual Personal Finance Writer and Educator dedicated to helping populations that need financial literacy and counseling. Her informative articles have been published in various news outlets and websites including Huffington Post, Fidelity, Fox Business News, MSN and Yahoo Finance. She also founded the personal financial and motivational site www.AcetheJourney.com and translated into Spanish the book, Financial Advice for Blue Collar America by Kathryn B. Hauer, CFP. Ana teaches Spanish or English personal finance courses on behalf of the W!SE (Working In Support of Education) program has taught workshops for nonprofits in NYC.