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What Is an Overdraft Loan? How They Work

What Is an Overdraft Loan? How They Work
Sulaiman Abdur-Rahman
Sulaiman Abdur-RahmanUpdated March 29, 2024
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
An overdraft loan is when a bank, credit union, or thrift institution pays for a customer’s transaction because the customer has insufficient funds. Depository institutions could decline debit card or checking account transactions whenever the customer has insufficient funds, or the financial institution may authorize the transactions and demand overdraft compensation.Banks may demand full repayment for the overdraft loan and may also charge $35 overdraft fees. Depository institutions may charge these fees whenever they cover a customer’s overdrawn transaction. Any customer with an overdrawn checking account is expected to make repayments.Some depository institutions may offer secondary overdraft loans after providing initial overdraft loans. Secondary overdraft loans allow customers with overdrawn accounts to repay their overdraft liabilities over a set term plus interest. Below we describe the pros and cons of overdraft loans.

Understanding Overdraft Loans

Overdraft loans are a form of credit. Banks, credit unions, and thrift institutions may provide overdraft loans whenever their customers attempt to spend more money than they have available in their deposit accounts.An overdraft occurs if you make a transaction that causes the available balance on your account to become a negative number. This can happen if the depository institution provides you with an overdraft loan as opposed to declining the transaction.Depository institutions may authorize an overdraft transaction or decline the transaction at their discretion. The terms and conditions of your deposit account agreement may require you to pay any overdraft liabilities charged to your account.An overdraft loan, for example, can occur if a customer with $3 in the bank makes a $15 recurring debit card transaction authorized by the bank. The bank in this case loans the customer $12 and may also charge a $35 overdraft fee. The bank would then require the customer to deposit enough funds to cover the $12 overdraft loan and $35 overdraft fee.Any customer with an overdrawn checking account is expected to make overdraft loan repayments. Some depository institutions may offer secondary overdraft loans after providing the initial overdraft loan. The secondary overdraft loan allows customers with an overdrawn checking account to repay their overdraft liabilities over a set term plus interest.

Does Having an Overdraft Affect Getting a Loan?

Having an overdraft may affect a customer’s ability to get a loan. Having an overdraft means your depository institution gave you a loan to cover a transaction that left you with a negative account balance. Depository institutions may report your negative account balance to consumer reporting agencies if you fail to repay the overdraft loan and fees.Carrying an outstanding overdraft balance is an adverse event that can trigger debt collection activities that may appear on your credit report as a delinquency. You may have a harder time getting approved for new loans if your overdraft liabilities are reported as delinquent.

How Does Overdraft Protection Work?

Depository institutions have no obligation to provide overdraft loans and may decline checking account transactions if the account holder has insufficient funds in the account. Depository institutions, however, may offer overdraft protection plans to give customers more control over what happens if they overspend from their available balance.An overdraft protection plan may allow customers to link their primary checking account with other eligible accounts, such as a savings account or credit card account. The secondary account provides overdraft protection if the primary account has insufficient funds to complete a transaction.Overdraft protection can transfer funds automatically from the secondary account to the primary account if the latter has insufficient funds to complete a transaction. An overdraft protection plan, for example, may transfer funds from a savings account into an overdrawn checking account to bankroll a transaction that may have otherwise been declined.Depository institutions in some cases may charge overdraft protection transfer fees. Using a credit card account to cover any checking account overdrafts, for example, may incur transfer fees and interest charges.

Pros and Cons of Overdraft Loans

Here are some pros and cons of overdraft loans:
Pros of Overdraft LoansCons of Overdraft Loans
May prevent a customer’s debit card transaction or checking account transaction from being declined due to insufficient fundsCustomers can incur high overdraft fees
Can cover bill payments and prevent checks from bouncingDepository institutions may provide the loan without customers being immediately aware of the overdraft
Can provide convenient liquidity when customers need it mostCustomers who fail to repay the loan can face debt collection activities and have their delinquency reported to consumer reporting agencies

Overdraft Loan vs Personal Loan

The important benefits of a personal loan include its potential to help consumers build a credit history. Initial overdraft loans, meanwhile, don’t contribute to a consumer’s credit history. Some depository institutions, after imposing the initial overdraft loan, may then offer a secondary overdraft loan that might contribute to your credit history in some cases.Among the personal loan fundamentals is the idea that consumers may use personal loan funds at their discretion. Depository institutions, meanwhile, decide at their own discretion whether to provide an overdraft loan when a customer has insufficient funds to cover a transaction.The disadvantages and advantages of personal loans include their potential to include high fees as a con and their potential to allow consumers to borrow up to $100,000 as a pro. Overdraft loans may also include high fees on what can amount to small sums of credit.A default on a personal loan can cause major damage to a consumer’s credit score. Likewise, defaulting on an overdraft loan could blemish your credit history if it’s reported to the credit bureaus as a delinquency subject to debt collection.

Applying for a Personal Loan to Cover an Overdraft

Applying for a personal loan to cover an overdraft is something a consumer may consider to remedy that situation. Lenders may offer personal loans as low as $250 up to $100,000, and you may deposit those funds into your checking account to repay your depository institution.As mentioned above, personal loans can include certain advantages and disadvantages. Before submitting any loan applications, consumers can evaluate their circumstances to determine whether they need to borrow money.

The Takeaway

Having insufficient funds in your checking account may impact your ability to make transactions. Banks, credit unions, and thrift institutions alone can decide whether to authorize checking account overdrafts. Depository institutions may charge high fees and demand immediate repayment if they pay for your overdrawn transactions with overdraft loans.

3 Lantern Personal Loan Tips

  1. Shopping around helps ensure that you’re getting the best deal you can. Lantern by SoFi makes this easy. With one online application, you can find and compare personal loan offers from multiple lenders.
  2. If the interest rates you’re being offered seem too high, try lowering the loan amount. Generally, the larger the loan, the greater the risk for lenders, who likely charge a higher interest rate for the increased risk level.
  3. Read lender reviews before taking out a personal loan. You’ll get a sense of how long it can take to receive the funds and how good the customer service is.

Frequently Asked Questions

What is an overdraft loan?
Can I get a loan with an overdrafted account?
What are the challenges with overdrafted accounts?
Photo credit: iStock/TARIK KIZILKAYA

About the Author

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman writes about personal loans, auto loans, student loans, and other personal finance topics for Lantern. He’s the recipient of more than 10 journalism awards and served as a New Jersey Society of Professional Journalists board member. An alumnus of the Philadelphia-based Temple University, Abdur-Rahman is a strong advocate of the First Amendment and freedom of speech.
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