How Does an Overdraft Line of Credit for a Checking Account Work?

Khadija Khartit is a strategy, investment, and funding expert, and an educator of fintech and strategic finance in top universities. She has been an investor, entrepreneur, and advisor for more than 25 years. She is a FINRA Series 7, 63, and 66 license holder.

An overdraft line of credit is a loan attached to your checking account. If you run out of money and you've been approved by your bank for this type of add-on, the line of credit can cover expenses so that you don’t bounce checks, miss payments, or have your debit card denied. Some banks also allow you to access the line of credit if you need emergency cash.  

Any money you use is provided as a standard loan from your bank, so you’ll pay interest on the amount you borrow. However, overdraft lines of credit are often less expensive than standard overdraft protection programs, which may charge around $35 for each rejected transaction that hits your account.   Still, some banks charge you a fee for each transfer from your checking line of credit or for each day that a transfer is made from your line of credit to your checking account.  

Understanding how a checking line of credit works and what your alternatives are allows you to cover unexpected expenses while avoiding the fees of a standard overdraft protection program.

How a Checking Line of Credit Works

Let's say that you have no money in your checking account, and then several small charges hit your account: $5, $6, and $7. You're now short by a total amount of $18. Let's say that your bank charges three overdraft coverage fees of $35 each, one for each item. That’s $105 in fees to cover $18 in charges.

With a checking line of credit, you'd instead borrow the $18 against the overdraft line of credit. The bank would charge you interest on the loan at a rate comparable to credit cards, and possibly a transfer fee, such as $5 per item covered.

If you repay the loan within a few weeks from the time that your paycheck hits your checking account, the interest charges might range from less than a dollar to a few bucks. Thus, you’ll pay no more than $20 in fees and interest for covering the expense from the overdraft line of credit instead of $105 with the standard overdraft protection—a substantial difference of $85. This benefit is even greater if you do this multiple times a year following your transaction activity level and the monitoring of your cash in and cash out timing.

Note

An overdraft line of credit is distinct from—and generally less expensive than—a standard overdraft protection program.

Penalties Without a Checking Line of Credit

It’s always best to keep a cushion of cash in your checking account, but leaving your cash idle also has a cost if you could be investing and growing it instead. To prevent this, you may limit the amount of cash you keep in your account.

But if mistakes or surprises catch you off guard, and you don't have a sufficient cash cushion easily available, an overdraft line of credit can provide a backup plan. If your checking account runs dry, and you don't have a line of credit linked to the account, the penalties will depend on the types of charges that hit your account and whether you have other overdraft protection set up for your account, such as standard overdraft protection.

• One-time debit card transactions: If you use your debit card for day-to-day shopping or ATM withdrawals, your bank might simply reject the transaction if your account doesn't have sufficient funds to cover it and you never opted in to any kind of overdraft protection, such as an overdraft line of credit. You may not even be charged a non-sufficient funds (NSF) fee by your bank in that case, as banks generally don't charge NSF fees for declined debit-based transactions. You can decide to use a different payment method or simply forgo the transaction. However, if you’ve opted in to some type of overdraft protection, you’ll use that service.
• Preauthorized payments: Recurring monthly bills that hit your account by ACH may still be processed by your bank, even if your checking account is empty. In those cases, you’ll likely be charged overdraft fees, even if you did not explicitly opt in to overdraft protection. If the ACH transaction is returned unpaid, you will pay NSF fees, which are comparable to the $35 per-transaction overdraft fee.
• Checks: If you write a check for more money than is available in your account, your bank may or may not allow the check to go through. Again, if you have standard overdraft protection, it will cover the check as long as the amount is within limits. If not, your bank may still pay the check and charge you for overdraft fees, or it may allow the check to bounce, which can result in NSF charges and other fees and headaches.

Note

Even if you did not opt in to overdraft protection, your bank or credit union may still charge you for overdraft fees if it pays a check or facilitates a recurring electronic payment that overdraws your account.

Pitfalls of an Overdraft Line of Credit

Having a loan to your checking account is less expensive than standard overdraft protection, and it allows you to keep spending in emergencies.   But it’s dangerous to depend too much on this form of overdraft protection for a few reasons:

• Interest charges: Overdraft lines of credit, while inexpensive, are not free. You’ll have to pay interest on the money that you borrow. If you only borrow for a day or two, the cost should be extremely low.
• Transfer fees: You might also have to pay a small fee every time you dip into the overdraft line of credit, so the more you use it, the more it’ll cost you.  
• Annual fees: Some banks charge a modest yearly fee to keep the service on your account. However small these fees, you’ll pay more in fees than you have to if you use your checking line of credit over several years.
• Limits: ​There usually aren’t any strict limits on how many times you can use an overdraft line of credit, but your bank may impose fees if you exceed the approved credit limit and may even cut you off if you use your overdraft line of credit too often. In addition, there is usually a dollar limit on the line of credit to prevent you from borrowing too much.   Depending on your credit and potential need, you may secure an overdraft line of credit for $500 or $1,000, although some banks offer lines with a credit limit of up to $10,000. If, however, your approved line of credit is insufficient to cover a transaction, it may not go through.
• Encourages overspending: Having a checking line of credit attached to your checking account is not unlike having a credit card; it can encourage you to spend money that you don't necessarily have in your checking account. If you depend on it too much, you could wind up with an overdraft loan and interest charges that you can't afford to repay.

Alternatives to a Checking Line of Credit

​If your main concern with an overdraft line of credit is overspending with your debit card, simply opt-out of overdraft protection. Your bank will reject debit-based transactions, and you can find another way to pay.

You can also link your checking account to a credit card instead of a line of credit. You will still owe interest on the amount you borrow, but you can avoid the $35 per-transaction fee for standard overdraft protection.

If, however, you are seeking a viable alternative to a line of credit, your bank might also allow you to link your checking account to a savings account. Instead of borrowing the bank’s money, you’ll use your own cash from the savings account. The fee for a savings transfer is generally similar to that of a line of credit transfer. You can also set up your checking account so that your savings account gets used before you borrow from a line of credit.

If you feel that the fees at your bank are exorbitant, shop around for different bank accounts that may charge you less in fees for standard overdraft protection or NSF charges.

Getting an Overdraft Line of Credit

To sign up for an overdraft line of credit, contact your bank. Some banks will require you to fill out an application, but not all will impose application fees for a checking line of credit.  

Be sure to ask about all associated fees and a list of alternatives, such as a savings account transfer. Once the checking line of credit is on your account, use it as rarely as possible to keep your overdraft loan at a manageable amount and your interest charges and transfer fees low.

If you have a line of credit linked to your checking account, it's best to balance your account and sign up for low-balance alerts so that you know when you’re running low on funds.