Mistakes happen. Sometimes you send out too many cheques or set up too many automatic bill payments without double-checking if you have enough to cover the costs altogether. When the balance sitting in your chequing account is too low, you’re going to go into overdraft. What’s wrong with that?
Going into Overdraft
An overdrawn account comes with several penalties. Important payments might not go through, forcing you to deal with consequences like late fees, interest hikes or service cancellations. Your cheques will bounce. Financial institutions refer to bounced cheques as Non-Sufficient Funds (NSF) because the account doesn’t contain enough funds to fulfill the transaction. When your cheque bounces, your bank can charge you a hefty NSF fee — it’s an average of $45 per NSF transaction. This simple mistake can sit on your credit report for six years.
Other than the initial fees, the danger of overdrafts is that you risk digging yourself into debt and making it difficult to get back out. One mistake with a transaction could lead you to struggle with an overdrawn account and the compounding costs for months and months. What do you do about your bills in the upcoming weeks? What do you do if you bounce another cheque? What do you do if there’s an emergency expense that you have to deal with? You could be stuck in a Dollar Draining Cycle of Overdraft for a long time.
So, what can the average person do to avoid the penalties that come with overdrawing their accounts? Banks offer up a simple solution: overdraft protection.
Overdraft protection is a safety-net for your chequing account. If the balance in the account is too low to cover an expense, you can still make an important payment or purchase. You’re not limited by the balance. There are significant benefits that come with this feature:
- You will not be cut off the moment that your balance hits zero
- Automatic bill payments like (utility bills, cheques for your mortgage, etc.) will not be rejected
- You will not need to turn to risky solutions like payday loans for quick financial support
- You will not be charged NSF fees
- Your credit rating will be unaffected
There are two types of overdraft protection: the bank can lend you funds to pay for the overdrawn transactions, or you can use one of your other accounts to carry the transaction. For the first type, the bank is essentially giving you a high-interest loan (up to a certain amount) to make up for the negative balance. The interest rate tends to be 19-21% per year. You will have to repay the loaned amount and the interest until your balance returns to the positive range. You will also be charged fees for going into overdraft and continuing to make transactions in that state.
Most banks require a monthly fee for this service, typically between $2.00 to $5.00. Some will have pay-as-you-go plans, charging a fee to every transaction. After you cross the threshold of the pre-approved limit, the bank will stop covering the transactions and you will be charged regular NSF fees, along with other penalties.
Banks sometimes offer premium plans that waive banking fees for their customers, giving them the opportunity to save over a hundred dollars per year while receiving the same essential services. Since these are premium plans, customers are expected to maintain a monthly minimum balance of a few thousand dollars. It’s a great perk for customers who can achieve that goal, but it’s not much of a comfort for people who are living from paycheque to paycheque.
If you don’t want to repay a high-interest loan, you can try the second type of overdraft protection. Link your chequing account to another account to cover any transactions that go into overdraft. You can set it up with a line of credit, credit card or a savings account, as long as it’s connected to the same bank. The arrangement essentially creates a back-up plan for whenever your balance is too close to the bottom.
The Downside of Overdraft Protections
In general, overdraft protection is a good thing. When you’re struggling with your finances, it’s an effective way to keep yourself from racking up fees, missing important payments and putting yourself into a vicious debt cycle. But, you shouldn’t be using it all of the time.
Some people build a dependency on overdraft protection because it feels like a safety-net that catches them over and over again. The feature still costs money to arrange with the bank, and it puts you in a position where you’re consistently making repayments, whether it’s to your chequing account or credit card. More importantly, relying on the protection fosters a risky attitude. You can’t be so relaxed about your personal finances. You need to get control of them so that you make the most of your money and avoid expensive consequences.
Think of overdraft protection like a life jacket. It comes in handy when you’re in the deep end, and you’re straining to keep your head above water. But, you won’t need to wear it once you learn to swim. You won’t need the help anymore.
Plus, there’s no guarantee that you will be able to qualify for overdraft protection. Your bank will look over factors like your income, debts, loans and credit history to see what overdraft limit they will offer or if they will approve the arrangement at all. There is a possibility that it won’t be available to you.
The good news is that there are other ways that you can prevent yourself from going into overdraft, without having to rely on overdraft protection.
Choosing Paper over Plastic
One way to prevent moving into overdraft is to start using cash over debit or credit cards for everyday purchases. You likely won’t be able to use cash to pay for essentials like utility bills, insurance payments and rent, but you can at least use it for expenses like groceries, toiletries and gas. Anything that can be easily purchased with cash should be.
The reason for this simple switch is that cash makes it more challenging to go over the limits in your bank account by accident. When you stick with cash, you realize that you’ve overspent when you run out of cash. When you use your debit card, you don’t have to think of your remaining balance — you just swipe or tap and hope that the purchase goes through. Cash gives you clear boundaries.
Another interesting fact about this spending solution is that using cash hurts more than payment methods like debit and credit. In 2016, an assistant professor at the University of Toronto Scarborough, Avni M. Shah, found that spending with cash created a stronger negative reaction in the buyer than other forms of payment. This is likely because the payment is more physical. You count your money. You tuck it in your wallet. You hand it over to the cashier. When you make a purchase, you can see that you’ve lost something to gain something else.
Paying with cash feels like more of a sacrifice. That feeling has two significant benefits for anyone who is looking to revise their personal finances:
- It takes away the temptation to spend more than you need to
- It makes you more emotionally attached to your purchases
So, choosing paper over plastic will encourage you to spend less and appreciate your purchases more. It’s a win-win situation.
Tracking Your Spending
The first way to avoid spending your funds on overdraft protection fees and interest rates is to track your spending so that you don’t make transactions that go beyond the contents of your bank account.
Start by getting into online banking. You can easily monitor all of your deposits, withdrawals and pending transactions without having to talk to a bank teller or take a trip to an ATM. Download the banking app onto your phone so that you can check your account at a moment’s notice. So, if you’re worried that your grocery bill is going to drain your account, you can open up your phone, check the app and see whether you’re okay to swipe your card, or if you have to put some items back on the shelves.
You should also log your expenses in a notebook or on a spreadsheet. After a few weeks, you will start to notice patterns that have been sitting right under your nose. You could see that you spend over $100 on espresso drinks in a month, or that you pay for a magazine subscription that you don’t even read anymore, or that you’re racking up lots of late fees.
Don’t just do this with your chequing account. Track your spending with your credit card, your line of credit or any other method of payment that you have. You can’t be responsible with one account and reckless with the others. To get full control of your finances, you have to track everything.
Check Your Accounts
The way that you’re managing your bank account — or bank accounts, plural — could be contributing to your overdraft habit and setting you up for debt trouble. Set aside some time to look at the fees, interest rates and benefits you are getting through your current bank. Then, research what other banks are offering for those same services. Is there a cheaper plan at your bank? Are there benefits you’re missing? Would you be better off at a different institution?
If you’re not sure whether you need to make a change, you should check out this financial quiz to get a clearer answer about the state of your personal finances. It will put all of your bank accounts, your spending habits and your debts under a microscope so that you can see all of your issues up close. You can’t fix something that you didn’t notice before.
Make a Budget
Now that you’re more familiar with your finances, you can put together a responsible monthly budget. You will need a spreadsheet. Start by writing in your monthly income, along with the remaining balance sitting in your chequing account. Tally it up. Then, you will have to input your costs:
- Fixed costs are costs that do not change in price, no matter what time. Examples are mortgage payments, property insurance payments and rent.
- Variable costs are costs that vary in price. Examples are grocery bills, entertainment costs and clothing purchases.
Put your costs in the spreadsheet and subtract them from your total income. If you’re often going into overdraft, you probably won’t have much leftover. So, you’ll need to find areas of the budget that you can trim down to save money. This is what variable costs are for. You can shrink your spending on things like entertainment, takeout, groceries and transportation.
You don’t have to do this process with pencil and paper. Download an app like You Need A Budget or Mint to put together a realistic and reliable budget on your phone. You’ll be more likely to hold yourself accountable to your budgeting boundaries when it’s sitting in your front pocket. It comes everywhere with you.
Making a budget is essential for avoiding overdrafts. It’s a useful guide that can help you avoid overspending, keeping you focused on essential purchases. It’s also an effective tool for cutting down costs and saving money, which will give you a great financial safety-net. Use the savings to bulk up your chequing account or store it into a separate savings account for an emergency fund. This back-up plan won’t have consequences like high-interest rates and penalties.
Get Professional Help
If you’re still struggling with overdraft repayment after making these important changes, you should visit a licensed insolvency trustee firm. Click here to see how our debt management specialists can help you with your financial issues and get you back on track. Sometimes, you need a little professional guidance.
In reality, the best way to prevent overdraft is NOT to sign up for overdraft protection. To stop your balance from dipping below zero, you can take on effective financial habits: tracking your spending, following a budget and investigating your bank accounts. And if all else fails, you can still go to a trained professional to get help and pull your chequing account back into the clear.