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Is overdraft protection a good idea?

Kathryn Elizabeth Tuggle is a seasoned New York-based personal finance editor and writer who adores saving, investing and thrift store shopping. After getting her start writing about small businesses for the Inc. 500 at Inc. Magazine, Kathryn learned her way around the NYSE and NASDAQ while working at the The Financial Times. In 2007, Kathryn joined the Fox Business Network before its inception and was instrumental in launching the company's small business and personal finance sites. Obsessed with all things spending, saving and social media, you can find Kathryn tweeting her latest adventures with Dimespring at @KathrynLizbeth. 

With car insurance, life insurance, identity theft protection and travel insurance, there are as many ways to protect your finances as there are to mess them up. When it comes to banking, consumers can sign up for overdraft protection to insure against overdrawing an account. But for responsible money managers, is it worth it? We checked in with experts to find out the pros and cons of overdraft protection.

On the surface, overdraft protection sounds like a great idea — if you’re making a purchase with your debit card and you don’t have sufficient funds in the bank, your bank will automatically transfer funds from a linked account (such as a savings account) to cover the purchase.

Consumers can avoid being embarrassed in the check-out line, but they can also rack up some hefty fees — anywhere from $10 to $35, according to a survey by Bankrate.com. 

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“The old adage ‘prevention is better than cure,’ comes to mind when the subject turns to overdraft protection,” says Niall Wells, CEO of online budgeting tool Planwise. “But for many small businesses or low income earners, overdraft protection can prove more effective than the fees from the bank.”

And while the fees usually aren’t horrible, they can add up if you make a habit of overdrawing your account. Bank of America and Chase both charge $10 every time they have to transfer funds into your checking account. At Wells Fargo, overdraft protection fees are $12 if the amount needed is $50 or less — but that fee jumps to $20 if the amount exceeds $50.

Although most people have overdraft protection set up to transfer funds from a savings account into a checking account when an overdraft occurs, a business account or a joint account shared with a spouse or parent will also work. But even more important than choosing which account to link is reading the fine print — even with overdraft protection, you can still be charged an overdraft fee if you run out of funds in your back-up account.

READ: Six steps to a great financial plan

“If you do choose overdraft protection, ensure you have messaging services (either email or text) from your bank to alert you to the overdraft to avoid high interest fees that may be assessed,” says Wells.

Your bank can alert you if you’re getting close to running out of money in all your accounts.

“Technology can certainly be your strongest ally when you maintain a low account balance and process numerous transactions,” Wells says. “In short, overdraft protection is useful if you can manage it, but prevention by managing your balance is always better.”

Andrew Schrage, founder and CEO of personal finance blog MoneyCrashers.com, says that overdraft protection isn’t necessary for people who have no trouble managing their money.

“I don't think you need overdraft protection,” Schrage says. “If you don't opt-in for such a service and you attempt a transaction for which you don't have sufficient funds, then the purchase will simply be declined.”

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In most cases, overdraft protection is a service for those who can't manage their own finances effectively, or those who are concerned about the embarrassment of a declined transaction, Schrage says, adding that he would rather have a transaction denied than be forced to pay a fee for the purchase to go through.

“Ultimately, overdraft protection allows people to spend more than they have, which is not a cycle one should get into,” he explains. “Furthermore, if you simply remain aware of your bank balance, overdraft protection becomes essentially useless and an excessive fee.”

For most consumers, there’s no need to link your checking account to your savings account, Schrage says. It’s possible to institute your own “overdraft protection.”

“For instance, make a deposit of $100 into your checking account, but do not record it on your transaction register where you balance your checkbook,” he explains. “That way, you have a built-in cushion of extra funds that you are not taking into consideration when you make your spending decisions. This strategy has worked well for me in the past when I've made purchasing mistakes, but have been covered by my financial cushion.”

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A Breakdown of overdraft protection’s pros and cons from Claes Bell, an analyst at Bankrate.com:

Pros:

  • No need to worry about being embarrassed at the check-out line. As long as there are sufficient funds in your linked account, you’ll be covered for the price of the bank fee.
  • In emergency situations like running out of gas or getting a flat tire, you’ll be guaranteed enough money to get yourself home or cover the cost of the repairs.
  • If money is tight between paychecks, you’ll have enough funds to get you through till the next payday.

Cons:

  • Fees can add up quickly.
  • If you do end up overdrafting your main account as well as your back-up account, you could be liable for hefty fees.
  • Overdraft fees are assessed on a per-day basis. If your bank charges fees of $10 per day, you could be looking at a hefty $70 charge at the end of a week of overdrafting.
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