The History of Overdraft Fees

Overdraft fees are a wolf in sheep’s clothing. While a bank often markets overdraft protection as a way to help you out when you make an occasional budgeting error, it’s really just an expensive form of credit.

Think about it: in 2014, the Consumer Financial Protection Bureau (CFPB) found that the majority of overdraft fees were charged on transactions of $24 or less. With a median fee of $34 at the time, the same type of charge on a loan for a similar three day period would result in an annual percentage rate (APR) of 17,000%.

How did we get to this point? And what can you do about overdraft fees? Read on to learn more.

A short history of overdraft protection

An overdraft occurs when you’ve written a check, taken a cash withdrawal or used your debit card in an amount that exceeds your available funds. Most banks and credit unions offer overdraft protection, and this covers your shortfall in exchange for a fee.

The first overdraft authorization happened in 1728, according to the Royal Bank of Scotland. An Edinburgh-based merchant named William Hog received permission from his bank to temporarily withdraw more money from his account than he had available. This cash credit, as it was termed, was the forerunner of the modern overdraft. At one point, 18th-century philosopher David Hume called the cash credit idea “one of the most ingenious ideas that has been executed in commerce.”

But, let’s now think about this in terms of modern times. In 2017 alone, consumers paid $34.3 billion in overdraft fees, according to PYMTS.com. So, it’s possible that if Hume knew what would become of the cash credit idea, he may have changed his tune.

The modern overdraft

It’s unclear exactly when banks started charging overdraft fees. But according to Moebs Services, a research firm that focuses on financial institutions, these fees have steadily increased over time.

In 2000, for instance, the median overdraft fee was $20 among banks and $15 at credit unions. In 2017, those fees increased to $30 and $29, respectively. That said, some of the biggest banks in the U.S. charge between $34 and $36. While there are still some institutions that don’t charge fees on overdrafts of less than five dollars, this is not a universal feature. Also, some institutions charge extended overdraft protection, which adds more fees if you don’t bring your balance back to zero within a certain period. These time periods can range from one day to a week.

What you can do to avoid overdraft fees

While overdraft fees are ubiquitous, it’s possible that you’ll never have to deal with them. For starters, you can budget your money in a way that you never overdraw your account. And, if you make a mistake, you can also get your account back in the black before the end of the business day.

There are also three things you can do to boost your chances of never paying an overdraft fee. Take a look:

1. Opt out of overdraft protection

In 2009, the Federal Reserve Board announced a new rule prohibiting financial institutions from charging overdraft fees on ATM and one-time debit card transactions unless the customer opts in for overdraft protection on these transactions. The rule, which was made under Regulation E, went into effect on July 2010.

Yet, according to a 2017 study by The Pew Charitable Trusts, nearly three-quarters of people who overdraft don’t know they have the right to opt out. Guess what? You can opt out! By doing so, any transaction that overdraws your account will simply be declined.

This may not be ideal in some situations. For example, a credit card company may charge you a returned payment fee if a payment doesn’t go through due to an insufficient balance. For other transaction types, however, the only negative impact from a declined payment may be an embarrassment.

2. Get an account with a bank that offers alternatives

Rather than charging a flat fee every time you overdraw your account, some banks offer less punitive forms of overdraft protection. For example, some banks set up automatic withdrawals from a savings account to cover overdrafts.

Let’s say you overdraw your account on a Monday morning and your account is still negative at midnight. Instead of charging you an overdraft fee, the bank will transfer cash from your savings account to cover the negative amount.

Another option is an overdraft line of credit. Again, instead of charging you a flat fee, the bank charges you interest — say 18% — on the negative balance. While this might seem high, if you overdraw $24 and bring your account back to positive within a few days, the accrued interest amounts to pennies.

3. Get an account with a bank that doesn’t charge overdraft fees at all

With the rise of challenger banks, many new institutions have addressed some of the major issues with the traditional banking system, including the problem of overdraft fees.

If you open an account with Chime, for example, you’ll never pay overdraft fees. Period. This means you don’t have to find some other way to avoid the problem because there’s no problem to begin with.

The bottom line

Overdrafts have been around for a long time, but the penalties keep getting worse. The good news is that there are plenty of ways to avoid overdraft fees, and some financial institutions don’t charge them at all.

If you’ve paid an overdraft fee recently, it may be a good time to look into alternatives at your bank or switch banks altogether.