What it means
Without protection, a payment that exceeds your balance can be refused, which may mean a returned cheque, a missed bill or an angry supplier. Overdraft protection avoids this by moving money across at the moment it is needed.
The customer decides in advance which source should be used. There are several forms.
A linked savings account is the cheapest because it moves your own money, usually for a small transfer fee. A linked credit line or credit card is borrowing and carries interest, while a standard overdraft facility lets the account go negative up to an agreed cap.
The main advantage is certainty. Payroll, rent and direct debits go through, so a temporary gap does not damage relationships or incur late-payment penalties.
The main disadvantage is that the protection can hide a real cash flow problem if it is used regularly. Businesses should compare the fee for each option.
Some banks charge a flat fee each time protection is used, others charge interest only, and some charge both. The cheapest option for a single use may be the most expensive over a year of frequent use.
A nuance is that protection must usually be requested or switched on. Many customers wrongly think it is automatic, when the default may be for the payment to be refused.
Bank statements should be reviewed to see how often protection is triggered. A pattern of repeated use is a signal to raise the account buffer, speed up collections or talk to the bank about a more suitable facility.
In practice
Real-world examples.
Example
A freelance consultant links her savings account to her current account. When a tax payment of $1,500 arrives on a day her balance is $1,200, $300 is moved automatically. She pays a $5 transfer fee and avoids a penalty from the tax authority.
Example
A restaurant uses a credit line as protection for its supplier account. Slow trading in January leaves the account short by $4,000. The line covers the gap and the owner repays it from February takings with a month of interest.
Example
A student charity sets up protection so that rent is always paid. The treasurer reviews the account every month and notices the savings link is used four times in a quarter. She revises the budget to include a larger buffer.
Formula
Calculation
Net saving from protection = cost of the failed payment - cost of the protection
A small company has a supplier payment of $3,000 due on a day when its current account holds $2,200. Without protection the payment is returned, the bank charges $35 and the supplier adds a late fee of $60, so the cost of the failure is 35 + 60 = $95. With protection linked to a savings account, $800 is transferred for a fee of $10. Net saving = 95 - 10 = $85 for that single event.
Reading the result: protection saved $85 in this single event, but the saving only holds if it is used rarely. If the same $10 fee were triggered twice a month for a year, the cost would be 10 x 24 = $240, and the better solution would be to hold a larger balance in the current account.
When choosing a source, compare the cost per use. A $10 transfer fee to cover $800 is 1.25% of the amount (10 / 800), while a credit line charging 18% a year costs about 800 x 0.18 x 10 / 365 = $3.95 in interest if it is repaid after ten days, so the cheaper option depends on how long the shortfall lasts.Case study
Seen in the real world.
Marlowe Design Studio is an illustrative, fictional agency that invoiced clients on 60-day terms. Twice in a year, payroll fell short by a few thousand dollars because a client paid late, and the bank returned the payments.
The agency linked a deposit account holding $15,000 to its current account as protection. The next time a payment was late, $6,000 moved across automatically and payroll went out on time for a $15 fee.
The owner also noticed that the protection was being used every quarter. The illustrative conclusion was that the cover was working but that the business needed a bigger cash buffer or faster collections.
Watch out
Common mistakes.
- Assuming overdraft protection is switched on by default, when it usually has to be requested.
- Treating protection as free money, when transfers, interest or fees apply every time it is used.
- Using protection regularly instead of fixing the underlying cash flow gap.
Questions
People also ask.
Is overdraft protection the same as an overdraft?
Not exactly, as protection can draw on a savings account or credit line, while an overdraft lets the account itself go negative.
Which source is cheapest?
A linked savings account is usually cheapest because it moves your own money, while credit cards and lines of credit charge interest.
Does it affect credit scores?
Using a credit line as the source can raise your balance and utilisation, which lenders may see when reviewing your credit.
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