Overdrawing a bank account can happen to anyone regardless of their earnings. For example, someone could have a delayed deposit making it into their bank after an automatic withdrawal.
But what happens when you overdraw your bank account? What are the potential direct (or indirect) impacts of an overdraft on your credit?
What Is an Overdraft?
“Overdraft” is the term for when someone doesn’t have enough money in an account to cover an expense at the time of withdrawal (i.e. through an automated payment or cheque). What happens when an account is overdrawn will depend on the bank/lender’s policies.
For example, a bank may refuse the transaction and charge the account owner a Non-sufficient funds (NSF) fee. NSF fees can be quite high—most Canadian financial institutions charge $45 per transaction. In this case, not only will your transaction not go through (resulting in an unpaid debt), but you’ll also owe an additional $45 to your financial institution.
If you have overdraft protection, overdrawing your account works a little differently.
What Is Overdraft Protection and How Does It Work?
Overdraft protection is an optional service that allows you to overdraw your bank account balance if you do not have enough money there to cover a financial transaction. The bank lends you the amount by which you are short. It can cover transactions like debit purchases, bill payments, cheques, withdrawals, and bank account transfers. This can help you avoid declined transactions and NSF fees.
If you have signed up for overdraft protection with your financial institution, your bank will provide a small “loan” to allow the purchase to be completed. In order to get overdraft protection, you must apply through a credit application. If you are approved, the bank will set your limit based on your creditworthiness and when you go into overdraft, the bank will charge you an overdraft fee, typically around $5, plus an applicable overdraft interest charge.
Some banks may have a form of overdraft protection that allows you to link your account to another financial product and withdraw the money from that other product to cover overdrafts. For example, if you have both a chequing and a savings account with the same bank, they may have a policy in place that will use the balance in your savings account to cover an overdraft in your chequing account. Another financial product you could link would be a line of credit. The bank might charge a fee for this service—though it varies from one bank to the next and even from one type of linked financial product to the next.
How Do Overdrafts Happen?
Overdrafts can happen for a variety of reasons. For example:
- Making a purchase assuming that a deposit has cleared when it hasn’t.
- Forgetting about an outstanding cheque that hasn’t been cashed yet while making purchases from the same account.
- Sudden and unexpected emergencies that cost more than you have set aside in your emergency fund.
- Automated renewals of subscription services or delayed payments that you forgot about causing you to overestimate how much money you have available.
- Erroneous or fraudulent charges that you could not account for because you didn’t know about them or how much they were.
These are just a few situations which could cause an overdraft. In some cases, you may be able to work with your bank to resolve an overdraft and avoid the fee—particularly if you can demonstrate that the charge was erroneous or caused by fraud.
Overdrafts and Credit Scores: The Direct Impact
What happens to your credit score if you go into overdraft? The short answer is nothing. An overdraft will not have an immediate impact on your credit score.
If you have a form of overdraft protection that covers the excess spending so your account does not go into default—or if you’re able to pay back the missing money before the end of your banking statement period—you should not see an impact to your credit score just from the overdraft.
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“While it can be helpful, it is important not to rely on an overdraft as it is a form of credit. Relying regularly on an overdraft is a warning sign that you are not on track with your budget. If you find yourself relying on overdraft protection, go back to the "ABC"s of budgeting - Analyze, Brainstorm, Change. Analyze your expenses by making a list of all your expenses. Brainstorm ideas to cut spending and/or increase income. Change your spending and/or income based on what you chose to do from your brainstorming."
- Becky Western-Macfadyen, Financial Coaching Manager, Credit Canada
Indirect Consequences of Overdrafts
While an overdraft or NSF fee doesn’t have an immediate and direct impact on your credit score, there could be indirect impacts from having insufficient funds in your account.
Bank Balances Being Sent to Collections
For example, if your account has a negative balance for too long (typically 60-90 days), it could be sent into collections. This would appear as a negative event on your credit history and lower your credit score.
To avoid this, it’s important to repay the overdrawn bank balance as soon as possible.
Unpaid Debts from Bounced Cheques/Card Transactions
Say that you write a cheque that bounces because of insufficient funds. The bounced cheque itself will not get reported to the credit bureau. However, the unpaid balance may be reported to a credit bureau as an outstanding debt and hurt your credit score.
If your bank reports that a cheque has bounced and you have not heard from the business you sent the cheque to yet, reach out to them as soon as possible to set up an alternative payment arrangement.
7 Tips for Managing Overdrafts Effectively
So, what can you do to avoid overdrafts and minimize the impact of overdrafts on your credit score? Here are a few tips that can help:
1: Ask What Kind of Protection Your Bank Offers
When setting up a new bank account, check to see what kind of overdraft protection the product has available. For example, can you set up automatic transfers from a savings account to a chequing account? What are the fees for the overdraft protection?
Knowing how overdrafts work on your bank account can help you avoid or prepare for any associated costs or impacts.
2: Track Your Monthly Income and Expenses
The best way to deal with overdrafts is to avoid them in the first place. One way to do that is to use a budget planning and expense tracking tool to verify how much money you make each month versus how much you spend (and what you spend it on).
This can help you more accurately assess how sustainable your current spending habits are and identify areas where you could make cuts. Knowing this can help you avoid overdrafts as it empowers you to ask yourself, “Can I really afford this?” and have a clear answer.
3: Cancel Auto-Renewing Subscriptions
How many subscriptions do you have that renew each month for services that you don’t use? Multiple small transactions can end up costing you quite a bit when you’re in overdraft. For example, say your bank has a $5 account overdraft fee for each transaction that happens while your account has a negative balance.
While you’re waiting for a deposit to clear, each transaction you make will cost an additional $5—making a $9.99 Netflix subscription $14.99 instead.
4: Create a Monthly Budget and Stick to It
After tracking your income and expenses, create a monthly budget of what to spend and what to spend it on so that all of your needs are met, and your debt payments are made. Any money left over after meeting your needs can be set aside in your savings, invested, or set aside for your “rainy day” fund.
Keep track of how the prices for goods you routinely purchase change over time. This way, you can adjust your budget to account for the inflation in these expenses.
5: Follow Up with Companies After Receiving an NSF Notification
Odds are that if a transaction is declined because of insufficient funds, the company you’re interacting with will let you know. However, it’s easy to miss an email or have a message get lost in your voicemail inbox. So, when you get an alert from your bank informing you that a transaction was declined, it’s important to check what the transaction was for and to follow up with the business to resolve the issue.
For example, say that a debt payment was missed because of insufficient funds. By reaching out to the creditor proactively, you could take care of the payment or make an alternative arrangement before the bill becomes delinquent and hurts your credit score.
6: Frequently Check Your Bank Balance and Transaction History
Before making major purchases, log in and check your current bank account balance and recent transaction history.
Frequently checking your bank account online and verifying that it reflects your recent transactions before making a purchase can help you avoid accidentally overdrawing your account.
7: Contest Fraudulent Charges As Soon As Possible
If you see a charge on your bank account that you know you did not approve, contest it as soon as you possibly can. If necessary, reach out to your bank and ask them to replace your credit/debit card to prevent the fraudster from making more charges on your account that could cause you to go into overdraft.
The sooner you do this, the better, as it helps you avoid erroneous fees. Also, if you do incur overdraft fees because of fraud, your bank should work with you to remove the fees from your account. You should not be held responsible for transactions that you didn’t make or approve.
Conclusion
Monitoring your bank accounts to verify that you have enough money to cover your costs—and identifying ways to reduce your spending based on your income and necessary expenses—can be an invaluable way to avoid the problem of overdrafts. While an overdraft doesn’t directly impact your credit score, having a negative bank balance or missing key payments due to insufficient funds can impact your credit score.
Managing your finances is the best way to prevent overdrafts and save up money to get (and stay) out of debt while building up your credit score.
If you find that you’re consistently going into overdraft on your bank account or struggling to keep up with your minimum monthly payments on your debts, help is available. Reach out to Credit Canada for information about your debt relief options and how you can live a debt-free life.
