What Is an Overdraft Loan and How Does It Work?

Managing personal finances requires foresight, but unforeseen expenses can cause temporary account shortfalls. Financial institutions offer various services to bridge these gaps and provide flexibility. Understanding these options helps individuals manage finances and maintain transactional continuity.

What is an Overdraft Loan?

An overdraft loan is a financial service where a bank extends a temporary line of credit to an account holder when their checking account balance falls below zero. This occurs when a transaction is attempted for an amount greater than the available funds. Rather than declining the transaction, the bank covers the shortfall, allowing the payment to proceed. This service acts as a short-term credit facility, providing immediate liquidity.

The purpose of an overdraft loan is to prevent transactions, like debit card purchases or checks, from being declined due to insufficient funds. It differs from a simple overdraft fee, where a transaction is refused and only a fee is charged. With an overdraft loan, the bank temporarily lends funds, preventing inconvenience or penalties from a rejected payment.

How Overdraft Protection is Applied

Overdraft protection, which can include an overdraft loan, is an optional service that account holders must opt into with their financial institution. This agreement allows the bank to cover transactions that exceed the available balance in a checking account. Many banks facilitate this by linking the checking account to another source, such as a savings account, a credit card, or a dedicated line of credit.

When a transaction overdraws the account, funds are automatically transferred from the linked source or advanced by the bank. This protection applies to various transaction types, including debit card purchases, ATM withdrawals, checks, and ACH payments. The account balance becomes negative, reflecting the loan amount. The overdrawn amount and any charges are expected to be repaid with the next deposit.

Associated Fees and Charges

Using an overdraft loan incurs financial costs. A common charge is an overdraft fee, assessed per transaction that overdraws an account. These fees vary by institution, typically ranging from $27 to $35 per item. Some banks may also impose continuous or daily overdraft fees if the account remains negative for an extended period.

In addition to per-transaction and daily fees, interest rates may apply to the overdrawn amount, similar to other credit forms. These interest charges contribute to the overall cost of using the overdraft facility. While overdraft loans provide immediate financial relief, understanding the accumulation of these fees and interest is important for managing finances.