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Overdraft Fees Make Credit Cards the More Cost-Effective Option

By (view all posts by aksekar)
at 10:56AM Friday July 1, 2011
under Personal Finance

It's the first of the month. Bills are due, and you barely have enough gas to make it to the pump.  Over the next two weeks, you'll need to borrow $100.

If you're strapped for cash, you have a couple options. You can overdraw your checking account at a local ATM, add $100 to your credit card debt (let's assume a heavy-hitting cash back credit card with a 29.99% APR), or get a payday loan from Cash America. Given everything you've heard about credit card debt (mainly, don't do it), you'd think that your best option is to stick with your trusty checking account. The math, though, says otherwise.

If you overdraw on your account, you'll be hit with $35 in fees, which amounts to a 35% interest rate. A payday loan carries $17.64 in fees, about half of the overdraft charge. If you pay off all of your credit card debt after only one month, though, you'll only have accrued $2.50 in interest. We have a winner.

Sneak Attack

It's scary to think that up until August 15 of 2010, banks could sign you up for "overdraft protection" without your consent. This meant that if you didn't know your account was empty, you'd be charged $35 every time you took out more than your account balance. Forget about overdraft. Who's protecting you from your bank?

Since it was apparent people were being misled by the banks, the Federal Reserve required banks to get consent before trying to "protect" its customers. Consumers would have to agree, each time they overdraw, to pay the associated fee. Unfortunately, banks took this as a signal to start bombarding customers with requests to "opt-in" to the high-cost overdraft coverage, citing the possibility of having their cards declined. 

A recent study from the Center for Responsible Lending showed that most customers don't want anything to do with the coverage, and most of those who "opted-in" were simply mislead by clever and aggressive marketing ploys. Banks utilize scare tactics and misinterpretation to pin customers with a false sense of urgency or risk.

According to the study, 60% of customers who opted in were erroneously led to believe there was a fee for a declined debit card. and 64% mistakenly thought it would protect them from bounced checks. Shockingly, almost 50% opted in just to escape the flood of phone calls and junk mail from their banks.

Banks try to get new and existing customers to sign up for overdraft "protection" even though it's clearly not in their best interests. And how do they get away with this? They stick with the age-old line, "No one wants to look like a fool at the cash register."

Our take? Credit might beat out debit

Though it pains us to say it, you might be better off reaching for your credit card rather than overdrawing on your checking account when you find yourself in a bind. You'll actually come out ahead, despite common misconceptions. In terms of finding the right credit card to run up, look for a card with low introductory or ongoing APR, like a balance transfer credit card, which has the additional benefit of helping reduce existing credit card debt. Try to stay away from rewards credit cards, since they tend to have higher interest rates.

But in the end, nothing will save you more money than keeping a careful eye on your budget so you don't come up short at the end of the month. Remember that prevention is key, and smart spending habits and budgeting are all the (free) protection you'll ever need.

Anisha Sekar is a staff writer for NerdWallet, a credit card website that helps consumers find the right low interest credit cards for their spending habits.