How to Avoid Paying Your Bank $70 to Borrow $6 for 6 Days
The overdraft product for these checking accounts was designed many years ago to help wealthy individuals with short-term liquidity needs. Imagine you keep your funds in CDs, bonds and other investments. You have an emergency, and you need $1,000 for six days, before your next paycheck is received. You could sell your CDs, but you don't want to. So, you use an overdraft facility. If you are not charged an overdraft transfer fee and are only charged interest for the days that you borrow the money, than this could be a very useful tool. If your overdraft line of credit had a 10 percent interest rate, then you would only pay $1.64 to borrow $1,000 for six days.
The bank makes a nice profit in this transaction. The actual transfer of funds costs it nothing. The only real cost is the funding for the six days, which would be around 1 percent. In other words, it charges $1.64, pays 16 cents in funding costs and makes a tidy profit of $1.48. The customer wins (because she doesn't need to sell anything), and the bank wins (a handsome return on short-term money).
Extortionate Pricing Model
At some point in the last 30 years, overdraft protection in the United States transformed from a liquidity management tool for the wealthy to a short-term lending product for the poor. And the pricing model shifted from being reasonable to being extortionate.
Today, banks typically charge $35 per incident. And many banks charge extended overdraft fees. To borrow $6 for six days, you could spend $70. And it doesn't cost the bank anywhere near $70 to offer the service. Transferring the funds costs the bank nothing. And 76 percent of people repay the overdraft in one week. But rather than using an overdraft to optimize liquidity as the wealthy once did, minimum wage workers are using overdrafts by mistake, or just to get through the month.
In many cases, banks are more expensive in the short term than payday lenders. A typical payday lender charges $15 to $20 for every $100 borrowed. In our example, you are spending $70 to borrow $6 at a large national bank.
Extra Cash in Your Checking Account Isn't a Solution
As you would expect, as the price of overdrafts increased, their usage has declined. As the Consumer Financial Protection Bureau has reported, 8 percent of customers pay 75 percent of all overdraft fees. And these are the poorest people, who can't afford to keep a reasonable buffer in their accounts.
For those who have the money, avoiding overdrafts becomes a matter of pride. But to be sure they'll avoid overdrafting their accounts, people keep extra cash in their checking accounts at 0 percent interest.
Whenever you see a product that targets the poor and generates outsized returns, you should be suspicious. Banks have created a complicated maze of transaction posting rules (nearly half of banks still reorder transactions) to extract the maximum in fees from those who can least afford it. Imagine that you make minimum wage and have two children to support. You are $6 short of your electric payment. You have two choices: pay for the overdraft facility or pay your electric bill late and risk late fees and potential loss of service. This is just a short-term liquidity need, but -– due to your limited economic means -– you end up paying $70 to borrow $6 and keep the lights on. Banks could cut their fees by 80 percent and still make a good profit on these micro-loans.
Innovations That Add Competition
For those who want to avoid overdraft fees, some new options are emerging. Capital One 360 (COF) has modeled its overdraft product on the European system. You're given an overdraft line of credit, and you're never charged a fee for using it. You only pay an interest rate for the days that you borrow the money.
Many credit unions provide a similar offering. If you open a checking account at PenFed, you can set up an overdraft line of credit at a reasonable rate to meet your short-term borrowing needs.
I am often dismayed when I see people lecturing others that personal responsibility is all that is required to avoid an overdraft. I spend a lot of my time working with people who make minimum wage and work hard to put food on the table. If their child gets sick, for example, they will do whatever it takes to care for their child. And situations like that can mean the need to borrow emerges. The real solution to this problem is competition in the short-term borrowing market. The good news: credit unions and new entrants are starting to create some truly innovative products that will make it more difficult for banks to keep taxing the poor.
For the Other 90 Percent
As someone who has the luxury of an emergency fund, I don't like having to keep extra money in my checking account to avoid ridiculous fees. I would rather keep it in a high-yield savings account so that I can earn the interest. And if I make a mistake, I find it ridiculous that I would have to pay an overdraft fee of $35. I find it even more ridiculous that I can get that fee reversed if I call. In other words, the banks have set up a system where they charge outrageous fees that are reversed if you call and complain. That business model should not be rewarded.
Fortunately, new alternatives exist. I recently switched to Ally Bank (ALLY). My savings account pays 0.9 percent. If I make a mistake in my checking account, money is automatically transferred from my savings to my checking account. And there is no fee (because it doesn't cost the bank anything). Big banks pay 0.01 percent on a savings account and charge $10 to transfer money from a savings to a checking account as part of overdraft "protection." So, imagine you keep $20,000 in your savings account and make one mistake in your checking account. At Ally, you would earn $181 of interest and pay no fees. At a big bank, you would earn $2 in interest and pay $10 in fees (for the one transfer).
%VIRTUAL-pullquote-The math is clear: people would be much better off leaving the big mega-banks. %My favorite part of Ally: you can use your ATM card anywhere, and your ATM fees are reimbursed. So, not only do you earn interest and avoid fees, but you can use any ATM in the country absolutely free.
In addition to Ally Bank, many other accounts from new providers offer higher savings account rates and completely free ATMs. At MagnifyMoney (my website), we have reviewed thousands of checking accounts to see which is the cheapest, based upon your individual needs.
The math is clear: people would be much better off leaving the big mega-banks. Whether you are poor (and pay too much in overdraft fees), or you have a meaningful savings account (and don't earn anywhere near enough in interest), the time to compare, ditch and switch is here.
Nick Clements is the co-founder of MagnifyMoney.com, a website that makes it easy to cut your costs without cutting your lifestyle. He spent nearly 15 years in consumer banking, and most recently he ran the largest credit card business in the U.K.