Remember to wear black Aug. 15, because that’s the day the infamous $35 latte may finally meet its demise. From that day forward, a new Federal Reserve rule will prohibit banks from charging overdraft protection fees unless a customer opts in.

Overdraft protection is a service offered by banks that allows checking account holders to temporarily make purchases with a debit card even if they don’t have sufficient funds in their account to cover them. In effect, the bank makes a short-term loan to the account holder so his debit card isn’t declined at the register or an ATM machine. In return, the bank charges an overdraft fee of $10 to $35, according to an informal Bankrate survey.

“(The new law) puts the decision in the hands of the consumer as to whether they want overdraft protection for small-dollar transactions conducted by ATM and debit card,” says Greg McBride, CFA and Bankrate’s senior economic analyst.

However, the law doesn’t correct a consumer’s underlying spending habits, McBride says.

“It doesn’t relieve consumers of the obligation to keep accurate tabs on their account balance,” McBride says. “Even though an ATM or debit card transaction won’t go through without our prior consent, if the balance is that low, the check written yesterday won’t clear and the online payment scheduled for tomorrow won’t clear.”

Contentious history

Overdraft protection became infamous with consumer advocates because consumers were often automatically enrolled in the programs without their knowledge and may have wrongly assumed that if they didn’t have the money to make a purchase, it would be declined.

“A lot of people use their debit cards several times a day, so you could easily rack up hundreds of dollars worth of fees,” says Leslie Parrish, senior researcher at the Center for Responsible Lending, in North Carolina.

And at an average of $27, according to Moebs $ervices, an economic research firm based in Lake Bluff, Ill., the fees were often much higher than the offending purchases, which averaged just $16, according to Parrish.

Still, it’s important to keep in mind that some banks’ and credit unions’ overdraft protection programs have better terms than others. Everything from per-transaction fees to limits on how many fees can be assessed in one day vary greatly by institution.

For instance, Chase charges a $34 fee every time it covers a purchase you can’t. In contrast, SAFE Credit Union, based in California, charges a $27, but waives fees for purchases less than $25 and only assesses the fee once a day, no matter how many purchases you make.

To opt in or not?

The Aug. 15 change is bad news for banks; the overdraft fees generated $37.1 billion in 2009, according to Moebs.

“(Banks) make a huge amount of money on this,” says Dean Baker, co-director of the Center for Economic and Policy Research.

To salvage some of that revenue and serve customers who’ve relied on overdraft protection in the past, banks have mounted campaigns to convince customers to opt-in to overdraft protection, says Richard Hunt, president of the Consumer Bankers Association.

“Banks by and large are getting customers to (opt-in) for overdraft protection because it’s a service (customers) are asking for and demanding,” says Hunt. “When Aug. 15 does occur and someone is denied a transaction, that will be the best way to get people to sign up.”

The pros and cons

If you’re trying to decide whether to opt-in, here are a few pros and cons to consider:

Pros:

  • Overdraft protection ensures those who agonize over being humiliated when being declined at the register will be shielded.

    “The argument the banks make is that people don’t want to be embarrassed,” says Baker. “They’re at the checkout counter or they’re at a restaurant, and they don’t want to have the person dealing with the debit card go, ‘You don’t have money in your account.'”

  • Overdraft protection can come in handy in emergency situations such as running out of gas or getting a flat tire.
  • It can provide a temporary, if expensive, float between paychecks.

Cons:

  • Considering how often many people use their debit cards, overdraft protection fees can balloon quickly, creating financial problems for consumers.

    “If you haven’t been following your balance closely, you can end up going into an overdraft situation on a very small purchase, and suddenly you’re liable for a very large fine,” says Baker.

  • Better rates of interest for small, short-term loans can be found at payday lenders. Even with payday lenders’ infamously high interest rates, a study last month by Moebs found the average customer who took out a $100 loan from a payday lender paid about $17.97 in interest and fees, compared to the $27 average for overdraft fees.
  • Many people would rather have a purchase declined and find alternative ways to make the purchase than be assessed an overdraft fee.

Opt-in alternatives

If you’re looking for a less expensive way to ensure you won’t be turned down for a purchase or face hefty nonsufficient funds, many banks and credit unions allow you to link your checking account to a credit card, savings account or line of credit.

“Anybody can slip up once, and that’s the type of protection you’d like to have. In the event you do overdraw the account, it’s just a matter of moving your money from one account to the other, not borrowing from the bank to cover the shortfall,” says McBride. “And the charge for that is very nominal — about $10 — based on a survey we did in 2007.”

One final note: If your bank charges you an overdraft protection fee after Aug. 15 and you haven’t opted-in, you can contact the Federal Deposit Insurance Corp. or the National Credit Union Administration to report it. The new Consumer Financial Protection Bureau will handle enforcement of the rule once it’s up and running.

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