An overdraft loan is a line of credit extended by the banking institution to cover negative balances in an account. These high-cost, short-term loans offer protection against fees for bounced checks up to a certain dollar limit—they cover automatic teller machine (ATM) withdrawals, debit card transactions, electronic transfers, and written checks. Overdraft protection does not automatically come with an account, and consumers must apply to the banking institution to add overdraft services. The benefit to adding overdraft protection is the interest rate associated with the overdraft loan is usually smaller than the high fees created by bounced checks. There are limits to how much an account holder may borrow, and privileges may be revoked by the bank for repeated or frequent abuse of overdrafts.
When an account holder writes a check or draft for more than the available balance in an account, it is known as an overdraft balance. The fees or interest associated with overdrafts can be costly if mistakes are repeated over time. An account holder may be subject to criminal prosecution in instances where the account is intentionally overdrawn numerous times.
An overdraft loan operates in various ways depending on the program and the banking institution. Overdraft protection is not always built into a checking account and is often subject to a credit check on the account holder. Pending approval, a line of credit is established on the account, which may be between $100 (USD) to $1,000 (USD) or more. When an item is presented to the bank for more than the account balance, the item is paid, then the account holder is charged interest on the overdrawn balance. The overdrawn balance is subjected to current interest rate fees for short-term loans.
There are negative consequences to an account which provides an overdraft loan or overdraft protection. The costs, fees, and interest rates associated with these types of loans are unusually high even if the original overdraft fees are higher. Continuous abuse of overdraft protection accounts may create future financial problems for the consumer, and misuse can affect how banks view the creditworthiness of a potential borrower for other types of loans. In addition, banks may decide to close an overdraft loan account or refuse to pay items presented against the checking account.