Overdrafts work like credit on your bank account. For example, let's assume that you have a medical expense to pay in the form of $200, but you don't have $150 in your account. You use your debit card to pay the bill, thus creating a -$50 overdraft on your account. Such charges have the potential to affect your credit score.
Overdraft charges will show up on your credit report in the form of debt. However, if you're diligent in paying your overdraft before month's end and you only occasionally have an overdraft, it might not show up in your credit report at all.
But what if you have your bank's permission to create overdrafts? Is there a difference between authorized and unauthorized overdrafts? We take an in-depth look at these two overdraft options and discuss how they can affect your credit, so keep reading to learn more.
What Is an Overdraft?
A bank overdraft occurs when a customer spends more money from their account than they have in it. This typically happens when a customer spends a large amount of money, and the money sits in their account for a few days before being available.
When an account is overdrawn, the customer usually incurs fees and penalties, which could lead to debt or having a poor credit rating. To avoid these consequences, it's best to know how to prevent them before they happen. Here, we provide some tips to help you manage your finances and avoid overdrafts. In doing so, you can continue to take steps to improve your credit score.
How Does Overdraft Affect Credit Score?
Overdrafts are a financial liability that can lead to costly fees and penalties. They're also one of the many reasons why your credit score is important. And if you want to avoid hurting your credit rating, you'll do whatever it takes to keep your credit score high.
Overdrafts are easy to get into, but they're hard to get out of. That's because banks will usually charge you an overdraft fee plus interest for each day (or few days) the overdraft remains unpaid.
Plus, these fees will show up on your account as "overdrafts." This will hurt your credit score in two ways: first, it'll show up as an unpaid balance; second, even if you pay off the overdraft within five to seven business days, you could still be charged a fee.
But this is far less problematic than your overdraft showing up in your credit report. So if you create an overdraft and your bank charges you a fee, pay it off in a timely manner, and you won't have to worry about anything reflecting in your credit report.
Failure to pay back your bank in time will, however, ultimately result in it showing up as debt, thus lowering your credit rating. This applies to both authorized and unauthorized overdrafts. The primary difference between the two is that you typically incur more penalties and interest when you create an unauthorized overdraft.
More like this: Do Medical Bills Affect Your Credit Score?
What Affects Your Credit Scores?
From overdrafts to inquiries, your credit score is vulnerable to many outside actions. As such, your credit score should be treated as one of the most important numbers in your life. It can determine whether or not you get a car, a loan, or a home.
As we've seen, there are ways to lower your credit rating, which can prevent you from moving forward and achieving your goals. So, what affects your credit score? There are five major factors. These include:
- Length of time with credit accounts
- Payment history
- Credit inquiries
- Amounts owed
- Credit mix
If you're looking to improve your credit score, it's important to understand what really matters when it comes to your wallet. That way, you can be proactive about bettering your situation instead of reacting to problems that might arise in the future.
Read on to find out how you can take steps to avoid overdrafts that could ultimately tarnish your credit rating. If you're used to overdrafting your account, you will need to remain committed to making a change in your spending habits.
How You Can Avoid Overdrafts
There are many ways you can avoid overdrafts. First, don't spend more than you have in your account. It's easy to get tempted by the feeling of unlimited funds when your bank gives you overdraft approval. But it's vital to your financial freedom that you don't take advantage of this feature. Instead, work to tighten your spending and minimize risk.
Create a Budget
Creating a budget will help you keep track of your balance so that you're aware of when your account starts running low. You can certainly pay your overdraft charge before the start of a new period, but it is absolutely imperative that you do so without letting your overdraft ride.
Protect Your Spending
Another option is to sign up for an automatic overdraft protection program with your bank that will transfer money from another account if there are insufficient funds in your checking account. This way, if there are insufficient funds, the transfer will happen automatically, and you won't be charged any fees.
You can also set up alerts on your phone about how much cash you have left in your account. This will help remind you when it's time to make a deposit or transfer money in order to stay within the limits of what's in your bank account.
Lastly, keep track of when checks are withdrawn from your account so that this doesn't happen at the wrong time and cause an overdraft when the check clears. If this happens, contact the bank immediately to request that they stop further transactions until enough money is available in the account.
If you're trying to avoid an overdraft with a checking account, your best bet is to transfer money into your checking account before it's needed. You can do this by setting up a transferring system or savings account and linking it to your checking account. This way, you won't be lacking the cash when you need it most.
Another way to stop overdrafts from happening is by not spending more than what's in your bank account. However, this may not always be possible due to emergencies or unexpected events such as car repairs or medical bills.
In these cases, set up a pre-authorized debit with your bank that would automatically take money out of your checking account if there isn't enough money available. If you're really desperate for cash and don't want to go into debt, you can do this for one day at a time—just make sure you take the money back out after 24 hours.
Limit Your Spending
If you find yourself constantly going over your bank balance, consider canceling some of the less important services like cable TV and gym memberships. Try scaling down other expenses like food or online shopping until you get back on track with finances. Remember: every little bit helps, so it's important to get serious about crunching your finances where possible.
Moreover, you may be tempted to use your credit cards to help you avoid overdrafting your bank account, but this isn't the best idea. Credit cards typically carry high interest rates and fees that can lead to debt if you're not careful. To avoid incurring these fees, use a credit card as a backup plan or for emergencies only.
If you need to use your card for an emergency, check your account balance before using it so you know what's available in your account. This way, you'll know how much money is available on the card and ensure that you don't spend more than what's in your account without realizing it.
How Opening a Line of Credit Can Help
If you're not sure how much money you'll need for the month, then opting for a line of credit might be a good option. A line of credit will allow you to borrow money when you need it and pay it back when you make more money.
Even if you don't use the full amount of your line of credit, this can be helpful because it can protect against overdrafts and missed payments in case the unexpected occurs. Having a cushion in place is a great way to avoid getting into debt.
So if you want to avoid overdrafts and missed payments, then a line of credit might be right for you. What's more, a line of credit is helpful if you know that your income will fluctuate periodically from month to month.
While most overdrafts won't show up on your credit report if you pay them on time, you should avoid making overdrafts a habit. Failure to repay your debt on time could very well affect your credit score. It's important to be proactive about your spending. Take the necessary steps to avoid overdraft charges so you can build toward the future.
More like this: Debit and Credit Cards: How Are These Different?
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.