An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation the account is said to be “overdrawn“. If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit, then interest is normally charged at the agreed rate. If the negative balance exceeds the agreed terms, then additional fees may be charged and higher interest rates may apply.
The first overdraft facility was set up in 1728 by the Royal Bank of Scotland. The merchant William Hogg was having problems in balancing his books and was able to come to an agreement with the newly established bank that allowed him to withdraw money from his empty account to pay his debts before he received his payments. He was thus the first recipient of cash credit from a bank in the world. Within decades, the advantages of this system, both for customers and banks, became apparent, and banks across the United Kingdom adopted this innovation.
With the onset of industrialization, new businesses needed an easy form of credit to jump-start their activities, without having to take out loans on securities they did not necessarily have. The importance of this new financial innovation was recognized by the philosopher David Hume who described it in one of his essays as “one of the most ingenious ideas that has been executed in commerce”.
Reasons for overdrafts
Overdrafts occur for a variety of reasons. These may include:
- Intentional loan – The account holder finds themselves short of money and knowingly makes an insufficient-funds debit. They accept the associated fees and cover the overdraft with their next deposit.
- Failure to maintain an accurate account register – The account holder fails to accurately account for activity on their account and overspends through negligence.
- ATM overdraft – Banks or ATMs may allow cash withdrawals despite insufficient availability of funds. The account holder may or may not be aware of this fact at the time of the withdrawal. If the ATM is unable to communicate with the card holder’s bank, it may automatically authorize a withdrawal based on limits preset by the authorizing network.
- Temporary deposit hold – A deposit made to the account can be placed on hold by the bank. This may be due to Regulation CC (which governs the placement of holds on deposited checks) or due to individual bank policies. The funds may not be immediately available and lead to overdraft fees.
- Unexpected electronic withdrawals – At some point in the past the account holder may have authorized electronic withdrawals by a business. This could occur in good faith of both parties if the electronic withdrawal in question is made legally possible by terms of the contract, such as the initiation of a recurring service following a free trial period. The debit could also have been made as a result of a wage garnishment, an offset claim for a taxing agency or a credit account or overdraft with another account with the same bank, or a direct-deposit charge back in order to recover an over payment.
- Merchant error – A merchant may improperly debit a customer’s account due to human error. For example, a customer may authorize a $5.00 purchase which may post to the account for $500.00. The customer has the option to recover these funds through charge back to the merchant.
- Charge back to merchant – A merchant account could receive a charge back because of making an improper credit or debit card charge to a customer or a customer making an unauthorized credit or debit card charge to someone else’s account in order to “pay” for goods services from the merchant. It is possible for the charge back and associated fee to cause an overdraft or leave insufficient funds to cover a subsequent withdrawal or debit from the merchant’s account that received the charge back.
- Authorization holds – When a customer makes a purchase using their debit card without using their PIN, the transaction is treated as a credit transaction. The funds are placed on hold in the customer’s account reducing the customer’s available balance. However, the merchant does not receive the funds until they processes the transaction batch for the period during which the customer’s purchase was made. Banks do not hold these funds indefinitely, and so the bank may release the hold before the merchant collects the funds, thus making these funds available again. If the customer spends these funds, then, barring an interim deposit, the account will overdraw when the merchant collects for the original purchase.
- Bank fees – The bank charges a fee unexpected to the account holder, creating a negative balance or leaving insufficient funds for a subsequent debit from the same account.
- Playing the float – The account holder makes a debit while insufficient funds are present in the account believing he will be able to deposit sufficient funds before the debit clears. While many cases of playing the float are done with honest intentions, the time involved in the cheque’s clearing and the difference in the processing of debits and credits are exploited by those committing cheque kiting.
- Returned cheque deposit – The account holder deposits a cheque or money order and the deposited item is returned due to non-sufficient funds, a closed account, or being discovered to be counterfeit, stolen, altered, or forged. As a result of the cheque chargeback and associated fee, an overdraft results or a subsequent debit which was reliant on such funds causes one. This could be due to a deposited item that is known to be bad, or the customer could be a victim of a bad cheque or a counterfeit cheque scam. If the resulting overdraft is too large or cannot be covered in a short period of time, the bank could sue or even press criminal charges.
- Intentional fraud – An ATM deposit with misrepresented funds is made or a cheque or money order known to be bad is deposited (see above) by the account holder, and enough money is debited before the fraud is discovered to result in an overdraft once the charge back is made. The fraud could be perpetrated against one’s own account, another person’s account, or an account set up in another person’s name by an identity thief.
- Bank error – A cheque debit may post for an improper amount due to human or computer error, so an amount much larger than the maker intended may be removed from the account. Some bank errors can work to the account holder’s detriment, but others could work to their benefit.
- Victimization – The account may have been a target of identity theft. This could occur as the result of demand-draft, ATM-card, or debit-card fraud, skimming, cheque forgery, an “account takeover”, or phishing. The criminal act could cause an overdraft or cause a subsequent debit to cause one. The money or cheques from an ATM deposit could also have been stolen or the envelope lost or stolen, in which case the victim is often denied a remedy.
- Intraday overdraft – A debit occurs in the customer’s account resulting in an overdraft which is then covered by a credit that posts to the account during the same business day. Whether this actually results in overdraft fees depends on the deposit-account holder agreement of the particular bank.
- Merchant overdraft – An unsecured overdraft offered by financial institutions to a merchant, and the amount overdrawn is within the authorized overdraft limit, which is usually of very high value.