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Why do Americans love overdraft?

By Claes Bell ·
Monday, February 28, 2011
Posted: 2 pm ET

Remember when we thought giving Americans a choice about whether to enroll in their bank's overdraft protection program would cut down on the amount of Americans' money banks were able to siphon off? Six months after the "opt-in" rule went into effect for checking accounts, the opposite is happening.

Suzanne Kapner of The Financial Times finds bank customers are chomping at the bit to sign up for overdraft protection and the high fees that go with it:

New research from Moebs Services, which analyzes financial data, shows that about 100 million of the 130 million U.S. checking account holders are on track to pay overdraft fees on ATM withdrawals and debit cards.

Among consumers who are overdrawn 10 or more times a year -- usually low-income people who can least afford the extra fees -- the "opt in" rate is higher, at nearly 98 percent.

As a result, Moebs expects banks to charge a record $38.5 billion in overdraft fees in 2011, up from $36.5 billion in 2010.

Craig Siegenthaler of Credit Suisse said some banks have "opt-in" rates as high as 90 percent. Notable exceptions are Bank of America, which last year stopped allowing customers to overdraw accounts on debit card purchases, and Citigroup, which has never allowed overdrafts on ATM withdrawals and debit-card purchases.

And just in case we've forgotten what overdraft protection really is -- a short-term loan at a rate of interest ranging from high to absurdly high -- here's Kapner:

"A 2008 Federal Deposit Insurance Corporation study found that a $27 fee for a two-week overdraft of $20 would be equivalent to an annualized interest rate of 3,520 percent."

I have to admit I'm surprised so many consumers are opting in. Part of it is probably attributable to convenience; people want to be able to make the purchase at the point of sale, even if they've accidentally spent all the cash in their checking account. Probably another contributing factor is lack of awareness of that incredibly high interest rate, coupled with aggressive marketing from banks.

But for some of those 98 percent of low-income bank customers opting in, I think the driver is a lack of sound options for small, short-term loans, especially for people with troubled credit histories. We're in a time of incredible economic stress for a lot of families, and a lot of people are living paycheck to paycheck and aren't always going to be able to make it until they get paid again, no matter how much they've scrimped and saved.

Banks, for the most part, don't offer small loans, and I'd bet a lot of people are hesitant to go to a title loan place or a pawnshop to solve short-term liquidity problems because they're afraid of being victimized by high interest rates and predatory loan terms, and/or losing their stuff. Credit cards would be a much better option, but they are only open to those with good enough credit to qualify for one, a group that's smaller now thanks in part to tighter lending standards adopted by banks.

For a big chunk of the 14 percent of banking customers that pay 93 percent of overdraft fees, that leaves bank overdraft protection as the favored solution. It's convenient, it's offered by big banks that consumers probably trust more than title lenders and pawnshops, and it allows customers some financial flexibility at an interest rate that, while monstrously high, is largely hidden.

But I doubt the problem lies entirely with the marketplace. I think for some, using overdraft protection as a borrowing facility allows them to stay in denial about the true state of their finances. Taking out a short-term loan takes deliberate action; it takes facing up to the fact that you don't have the funds to get by for the week and taking action to remedy the problem.

In contrast, overdraft is a passive action; you simply use your debit card as you normally would and take out de facto loans to cover each purchase automatically.

What do you think? Am I off-base? Why do you think people love overdraft protection so much?

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Debra James
March 03, 2011 at 3:28 pm

Claes, it would have been helpful if there was a little more clarity about the type of overdraft protection that is being discussed in the article? There is "courtesy" overdraft protection that allows the payments of certain types of transactions even when there are enough funds in the account to cover them. The bank can charge between $25-$35 for the few three transactions in one day.

There is also a bank service product called overdraft protection that customers pay a monthly fee for. The bank allows the customer to draw funds from an attached loan, credit card or savings account to cover an overdraft. Each of these transactions also incurs a fee in addition to the monthly fee paid just to have the service.

I believe you are talking primarily about the first type, courtesy overdraft protection. But I want to point out that the research may include both types of services. In this case, I can see why there would be a high percentage of opt-ins, because some people are trying to be proactive in addressing the probability of an overdraft by purchasing overdraft protection.

Claes Bell
March 03, 2011 at 3:28 pm

That's a good point, Debra. The research I cite is talking about the service banks provide where you pay $25-$35 after the fact for the bank covering your purchases at the point of sale with its own money. I've seen it called "courtesy" overdraft and "overdraft protection" by different institutions, but you're right, there is a difference. What you call "overdraft protection" is a much better deal, since the fee involved is usually much smaller. Good point and thanks for reading.

March 01, 2011 at 11:25 pm

It might be at least partially due to the aggressive and somewhat deceptive marketing of the overdraft protection option by some banks. I received relentless flyers and emails from my bank, which all threatened that I would find myself starving, stranded and/or unable to meet basic emergencies if I didn't sign up. They even sent me surveys to ask why I wasn't responding affirmatively to their campaign. It was pretty crazy.

Claes Bell
March 01, 2011 at 12:40 pm

Steve, I think title loans and pawn shops would actually be a cheaper way to borrow, oddly enough. I mean, with them you're looking at a 250% APR, which is horrible, but nowhere near a 3,000%+ APR. That said, the 3,000%+ number depends on the amount you overdraft, so the bigger your overdraft, the smaller the APR. Still, I hate to say it as a personal finance writer, but I think a title or pawnshop loan might actually be preferable. Tom, I agree that overdraft is outrageous, but at the same time, if people opt-in to the service, they must think they're getting some kind of benefit. The FDIC is going to be rolling out some guidelines about how much banks have to educate consumers about the perils of overdraft. But what do you do if someone just doesn't care? And what kind of real alternatives for short-term floats are really out there?

March 01, 2011 at 12:22 pm

Fees with excessive APRs should be outlawed. 3000+% is clearly excessive. There's no reason a 0.10 overdraft should cost you a $20 fee. Yeah it's a "free" economy but it lacks quite a bit of consumer protection. It's not really free anyway, it's just not regulated sufficiently in some aspects and over-regulated in others.

Steve Hane
March 01, 2011 at 12:38 am

Interesting take on this. I wasn't aware nor would I have suspected that customers would actually opt-in for overdraft "protection". I personally abhor such fees and avoid them like the plague. However, it does make sense in a twisted way that people with poor financial planning would find this a helpful, albeit very expensive, safety net. $25-$35 a hit for a short term loan doesn't feel like much, but the effect is that 3,000%+ APR you noted. Short term loans based on pawns, car title, or payday loans are likely to charge a comparable fee. It seems to me the banks get off easier and with less risk because their process is automated and their default rate is probably much less, but I could be wrong. Either way this fees add up really fast and keep people in poor financial straights.