When you have insufficient funds in your bank account for a transaction, you are usually either denied at the cash register, or you find your account overdrawn, and a fee as high as $45 is deducted from your balance as well.
Each of these situations is painful in its own way. But one way to avoid these issues is to make use of an overdraft line of credit.
What is an Overdraft Line of Credit?
Rather than providing you with simple overdraft protection, which results in the bank allowing you to overdraw your account, provided you are willing to pay a hefty fee, an overdraft line of credit is designed as a way for you to borrow money smoothly.
Usually, the overdraft line of credit is connected to your primary checking account. If you go over your limit, the money is added to your account from your line of credit automatically. Instead of being charged up to $45 for an overdraft, you are charged interest for as long as the balance is outstanding. In some cases, you might be charged a $5 fee, and there is a good chance that your overdraft line of credit comes with an annual fee.
Advantages of Overdraft Lines of Credit
The main advantages of overdraft lines of credit is that they often allow you large overdrafts from your account and that you can avoid the hefty per-item fees charged with standard overdraft protection. This can make it easier to manage your cash flow if your bills and your income don’t always match up. For those with variable incomes, an overdraft line of credit can be helpful in smoothing cash flow. I have an overdraft line of credit connected to my primary checking account as a backstop, just in case clients are late paying.
Another upside to overdraft lines of credit is the fact that, in many cases, your overdraft line of credit has a lower interest rate than a credit card. While you don’t want to get in the habit of carrying balances for long periods of time on any line of credit, the reality is that it’s often better to do so on an overdraft line of credit that charges 11.99% APR than a credit card that charges 19.99% APR.
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As long as you pay off the line of credit quickly, before interest can begin accruing, an overdraft line of credit can help you avoid hefty fees in the event of a mistake that leads to an overdrawn account, or in situations when your cash flow is tight. But, as with all forms of credit, you need to be careful not to rely primarily on an overdraft line of credit to help you manage your everyday finances.
Pitfalls of Overdraft Lines of Credit
It can be tempting to view your overdraft line of credit as available capital for regular expenses. You should view your overdraft line of credit as a lower-interest credit card, and try to stay away from using it regularly.
Once you get in the habit of viewing your line of credit as “extra” money, you run the risk of getting into serious long-term debt. Once this happens, you could easily find yourself paying more in interest than you bargained for. Additionally, you find yourself overwhelmed by debt. This can be especially problematic if you have used your line of credit to consolidate debt, and then you begin running up your credit card balances again.
Your overdraft line of credit can be a great tool to help you avoid big fees in certain circumstances. However, it’s much better to carefully manage your finances so that your need for this line of credit is very rare. Look at an overdraft line of credit as a backstop against unusual situations, and you will be in much better financial shape overall.
Image credit: Duncan