An overdraft line of credit is a loan arrangement between banks and some of their checking account holders. It offers them protection from overdraft fees and merchants' returned check fees when they spend more money than they actually have. This account feature can result in significant savings. To open a line of credit for overdraft protection it is usually necessary to apply.
An overdraft occurs when a person attempts to withdraw more money from a checking account than she has in it. There are several ways this can be done. A person may, for example, write several checks. All of the recipients of those checks may attempt to cash them on one day. Meanwhile, the account holder may have a debit card which she is using on the day the checks are cashed and she may spend money that is needed to cover her outstanding checks.
In this scenario, the account holder would have a negative balance because she does not have enough money to cover all of her transactions. This has often led to people accumulating a significant amount of debt, because generally each attempt to process a transaction unsuccessfully results in an overdraft fee. Overdraft fees can be thought of as penalties for insufficient funds. Furthermore, many merchants charge separate fees for transactions that cannot be processed.
To prevent this, some account holders have an overdraft line of credit. This arrangement is basically a very short-term loan. When a transaction needs to be paid and there is not enough money in a person's account, the bank will cover the payment. This loan prevents the account holder from having to pay merchant's returned checks fees and overdraft fees. The account holder must, however, pay interest and there may be a small fee for the service.
Checking account holders may be given the opportunity to sign up for an overdraft line of credit when they open their accounts. If not, there may be further opportunities to do so later. As is the case with other types of credit, overdraft protection is subject to limits. This amount can vary and will be determined based on a number of factors which generally include a person's credit history.
For some individuals this arrangement is a beneficial safeguard. For other people, it is a resource that allows them to make poor financial decisions. This happens because they use it to spend money they know is not in their accounts. In some cases, if a bank realizes a person is using the overdraft line of credit in this way, they will discontinue the arrangement.