How Overdraft Lines of Credit Work

Overdraft lines of credit are loans that are attached to the checking account. Instead of paying large fees and bouncing checks, you can borrow some money and pay interest. It is a contractual relationship wherein the bank pays overdrafts.

This kind of overdraft protection is unique in that you'll only pay for the borrowed amount; you'll not pay for the number of items you borrow for. This article covers how an overdraft line of credit generally works.

Getting an overdraft line of credit

You can get an overdraft line of credit if you meet the creditworthiness criteria that the bank established for such accounts. After filling out and signing the application, the bank runs through your credit and, depending on your credit quality, either approves or denies your application.

If you didn't set up an overdraft line of credit when you opened an account, ask your bank how to add it to the checking account.

Loan limit

Your bank will establish a limit for your overdraft line. The limit is based on your bank's policies. It also largely depends on your credit worthiness and bank's policies. The bank may be able to lend you $100 if you have low credit quality, or $1000, or more if you have good credit quality.

Costs

What are the costs? Typically you pay the amount you borrowed plus interest at a market rate. You may also have to pay a yearly fee to add to your account an overdraft line of credit.

Example

You've spent all money in your checking account, but 3 small charges hit your account totalling $15. Your bank may charge you $35 overdraft coverage fees for each item.

This means a fee of $105 to cover $15. Using your overdraft protection, you borrow $15 against the line, with interest at a market rate. Then you repay it within weeks once your paycheck hits your checking account.

Dangers of using an overdraft line of credit constantly

Many people abuse overdraft lines of credit. It's absolutely alright to have a safety net to protect you when you make financial mistakes, but you must not use it every now and then. Regularly using an overdraft line of credit suggests that you're not managing your money well.

Sure, you can always write a check against your empty account, but it's no good if this becomes a habit. One consequence is that banks may refuse to cover transactions. They may even close your overdraft line of credit. Here's a well-meaning advice: Don't misuse overdraft lines of credit.