The availability and easy access to financial transactions via bank accounts have welcomed updated and novel strategies for account holders, bringing diversity and functionality to the financial platforms. However, with a budding trend and upsurge in the number of bank accounts, the account holders are recommended to adhere to the specialists’ structural ideologies and strategies.
With each category of banking accounts, there are protocols and constraints about the procedure, limits, financial transactions, and funds availability that a few account holders generally disregard. One of the usual slip-ups occurs if an individual expends more than the economic threshold for accessible monetary resources. This common inaccuracy is recognized as a bank account overdraft.
What is a bank overdraft?
Bank overdrafts are financial arrangements that allow individuals or businesses to withdraw funds from their bank accounts, even if the account balance is insufficient, up to a pre-approved limit. For example, if you have $100 in your account and withdraw $120, the bank allows you to borrow a set amount of money.
The idea of overdraft is mainly affiliated with a checking account in which the individual consumes more than the available assets from the lending establishment, making the account touch zero. This materializes when the total limit is withheld from the accounts generating inadequate cash, leaving zero money.
A situation arises if additional or more than the limit money is withdrawn instead of the current funds stored in the account. If the mentioned agreement is implemented between the individual and the financial institution, then interest is applicable on the overdraft limit at an approved rate. However, the overdraft should be within the threshold for a nominal interest rate and not surpass the decided terms. As a result, the individuals charge a higher interest fee, paying the upper interest rate.
Credit scores are a numerical representation of your creditworthiness or how likely you are to repay debts. These scores are determined by a range of factors, including your payment history, the amount of debt you have, the length of your credit history, the types of credit you use, and new credit inquiries.
Does Overdraft Affect Credit Score?
Yes, an overdraft can affect your credit score if you avoid paying debts such as a personal line of credit, an auto loan, or a mortgage. In that case, the bank can report you to the credit bureaus and damage your credit score. However, other minor bank overdrafts do not affect your credit score directly, and overdraft information does not appear on any credit report.
When it comes to overdrafts, it’s essential to understand that they can indirectly affect your credit score, depending on the situation. Overdrafts occur when you withdraw more money from your bank account than is available. If this happens occasionally and you pay the overdraft fee immediately, it’s unlikely to affect your credit score because most banks don’t report overdrafts to the credit reporting bureaus.
However, the situation changes if your account remains overdrawn for an extended period. If you don’t repay the overdraft, the bank may send the debt to a collection agency. Debt collection activities are reported to the credit bureaus and can significantly negatively impact your credit score.
Sometimes, an overdraft may be linked to a line of credit, such as an overdraft protection line. Any usage and repayments could be reported to the credit bureaus if this is the case. Like any other form of credit, using the overdraft and repaying it promptly may help build your credit history. But if you miss payments, it could harm your credit score.
Another indirect way an overdraft can affect your credit score is through the “hard inquiries” on your credit report. The bank may run a credit check when you apply for overdraft protection or a bank account with overdraft facilities. These checks can cause a small, temporary drop in your credit score.
Bank Overdrafts and credit bureaus
A bank overdraft occurs when you withdraw more money from your bank account than you can. It allows you to spend more money than you currently have in your account, resulting in a negative balance. For example, if you have $100 in your account and withdraw $150, you would be overdrawn by $50.
In most scenarios, credit bureaus do not typically consider or pay much attention to overdrafts. Financial institutions are usually not concerned about overdrafts because it is not money borrowed or loaned by the individual; instead, their funds have been withdrawn. As long as overdrafts are managed responsibly, they do not impact your credit score.
Once you have paid off any overdraft fees and brought your checking account balance back to zero, you can continue using your account as before. However, if the overdraft fees are not resolved formally, the bank may send the situation to a collection agency for further evaluation. The collection agency may notify the credit bureaus, which can negatively affect your credit score. The collection account can remain on your credit report for at least seven years unless you work with the collection agency to resolve the overdraft status.
While overdraft fees do not directly affect your credit score, they can indirectly impact your financial standing and reputation if the bank does not receive payment for the overdraft amount. Resolving overdraft fees within the given time frame is essential to avoid potential consequences. The funds available in your checking account are not reported in credit reports because they are not borrowed money, so the likelihood of an overdraft fee appearing on your credit report is minimal and can be resolved quickly.
If you frequently experience overdrafts, it is advisable to opt for overdraft protection. Banks often provide the option to decline transactions if you attempt to use your card or checking account beyond your available funds. This feature helps prevent you from spending more than you have by restricting additional funds from being withdrawn from your linked account.
Practical Example of How Overdraft Affects Credit Score?
Consider a practical example to illustrate how overdrafts can impact your credit score.
Let’s say you have a checking account with Bank XYZ. You’ve had a hectic month and have accidentally overdrawn your account by $1500. The bank hits you with an overdraft fee of $135. So, you’re now negative $1635.
- Immediate Impact: You don’t immediately go to jail or take a hit on your credit score. It’s a common misconception that an overdraft directly affects your credit score – it doesn’t. However, the bank will expect you to cover the overdraft and any associated fees.
- Indirect Impact – Unpaid Overdraft: Imagine you fail to cover the overdraft and fee within a few weeks. Bank XYZ might close your account and turn the debt to a collection agency. Once this happens, the collection agency will likely report the debt to the credit bureaus.
- Effect on Credit Score: The collection account appears on your credit report as an unpaid debt. According to FICO, your payment history accounts for about 35% of your credit score. Having a collection account on your report indicates a failure to pay back what you owe, which can significantly harm your credit score. For instance, if you had a good credit score of around 700, a single collection account can drop your score by up to 100 points, pushing you into the “fair” credit range.
- Long-term Consequences: This unpaid debt will stay on your credit report for seven years, and potential lenders may be reluctant to extend credit to you during this time, given the evidence of default. Over the years, the impact on your credit score may lessen, but the blemish will remain on your report.
- Additional Consequences: Further, you may also find it challenging to open another checking or savings account because many banks use reporting agencies specifically for bank accounts (such as ChexSystems), and an unpaid overdraft could be a red flag for other financial institutions.
In conclusion, while an overdraft does not hurt your credit score, failing to pay it off can lead to a chain of events that does. Covering any overdrafts as soon as possible is crucial to avoid these complications.
A simple overdraft immediately paid back won’t typically affect your credit score. However, extended overdrafts, overdrafts sent to collections, or overdrafts linked to a line of credit can all potentially impact your credit score.
After leaving Wells Fargo Bank in 2014, Daniel began a career as a finance consultant, advising companies and individuals on economic policy, labor relations, and financial management.
At Promtfinance.com, Daniel writes about personal finance topics, value estimation, budgeting strategies, retirement planning, and portfolio diversification.
Read more on Daniel Smith's biography page.
Contact Daniel: daniel@promtfinance.com