Whenever you write a check or use your debit card, the money you use is taken out of your checking account. When the money you owe exceeds the amount of money you have available in checking, the extra money is called overdraft. Many banks will allow you to spend more than you have (at least temporarily) and charge you a fee each time you do. But why does overdraft even exist? Shouldn’t your bank just make it impossible for you to get credit for money you don’t have?
Normally, when you write a check for more money than your checking account contains, the check will “bounce” when someone tries to cash it, and your bank will charge you a fee. But some banks won’t fine you for bouncing a check if you use a service called overdraft protection. With overdraft protection, any overdraft you generate becomes a kind of instant loan – the bank lets you have the money, but you have to pay it back with interest. Interest on overdraft tends to be incredibly high, but as long as you pay it back quickly, it’s usually still cheaper than the fine you’d pay for bouncing a check. Your bank still profits from the interest, and it can also charge you a fee just to get overdraft protection in the first place.
It’s worth noting that you don’t have to have overdraft protection if you don’t want it; for example, if you turn off overdraft protection on your debit card, when you don’t have enough money to pay for something, the transaction simply won’t go through. In some cases it doesn’t make sense to have your bank let you go over the limit just so it can charge you, but when it’s used intelligently, overdraft protection can be worthwhile both for you and your bank – you save money, and your bank makes money.