How To Avoid Overdraft/NSF Fees

There is a long discussion on Wesabe Groups about overdraft fees. Some banks call it NSF which stands for Non-Sufficient Funds.

In case you don’t know, banks apply the debits in a way that maximizes the number of instances of overdraft. They sort the debits on a given day by the amount and apply them in descending order, the largest first, the smallest last. If a large debit produces an overdraft, each subsequent smaller debit on the same day also generates an overdraft. Because the banks charge some customers one overdraft fee for each overdraft occurrence, the more overdrafts, the more fees.

This post is not about whether such practice is fair or how sneaky banks are. You can read about that from the Wesabe Groups discussion and from the articles linked in it. I’m writing about how to avoid the overdraft/NSF fees.

There are basically three ways to avoid overdraft fees:

(a) Find a bank or credit union that doesn’t charge an overdraft fee. If they don’t charge a fee, you can have as many overdrafts as you want and still not pay any overdraft fees. Good luck at that.

(b) Avoid overdrafts by tracking the account closely. Diligently record every check, debit card purchase, and bill payment. Time the debits and deposits well and understand the bank’s funds availability policy. This may work for some people but it’s probably too much work for many others. Some banks give their customers a “get out of jail free card” by allowing one overdraft in a year without charge. If you manage your money well, that one forgiveness a year may be enough. For others, mis-timing will still happen.

(c) Avoid overdrafts by having enough money all the time. Duh! If you never have overdrafts, you will never pay an overdraft fee.

Let me expand on option (c). You know everyone is supposed to have an emergency fund that covers 3 months of living expenses. If you have enough money for 3 months without a penny of income coming in, then while you have income, no matter which order the banks apply the debits or how long they hold your deposits, you will never have an overdraft. There are several ways to ensure that you always have enough money for your debits:

1. Leave a cushion in your checking account. You leave some extra dollars in your checking account and never let the balance fall below a certain level, say $3,000. When the balance gets close to the low mark, transfer in some money from somewhere, like an online savings account or a money market fund. That way even if the timing of a withdrawal or deposit is off sometimes, you are still covered. I used to do this. This will avoid the overdraft fees but it also creates a dead balance in a usually no-interest checking account. At even 2% interest rate, the lost interest is $60 a year on a $3,000 cushion. If your checking account pays good interest, then there’s no problem.

2. Checking + Savings + Overdraft Protection. In this setup, there’s less cushion in the checking account. The extra money stays in a savings account at the same bank. You also sign up for the Overdraft Protection service which will tap your savings account in case there is an overdraft in the checking account. Using the Overdraft Protection service can still incur a fee but it’s usually less than the overdraft fee without the service. I’ve seen some banks charge like $10 per day regardless of how many items create an overdraft on the same day. $10 per day is certainly better than $35 per item. The problem with this setup is that the savings account has to be with the same bank which doesn’t necessarily offer a good interest rate and it doesn’t completely eliminate the overdraft fees.

3. Brokerage funded overdrafts. This is what I have now. I use Fidelity Cash Management Account, which I think is the best checking account that is not a checking account. You can leave everything in the “core” part of it if you like simplicity. It’ll work like option (1). Every dollar in the account earns some interest. You don’t feel bad about having a dead balance. If you want to be more aggressive and have something like checking + savings, just buy a money market fund in the account. The “core” is like the checking part. The money market fund is like the savings part. The overdraft protection from the money market fund is automatic. There is no enrollment and there’s no fee. It just happens. If you don’t have enough balance on the core side when a debit comes in, your money market fund is automatically tapped for the difference. Neat. Some people go to the extreme of having $0 in the core and everything in a money market fund. I’m not that aggressive. I still leave a few thousand dollars in the core because I like to settle for good enough. Getting 2% sure beats 0% which I had before.

Now that I have Fidelity Cash Management Account, I can go out of the country for 3 months without pay and still have all my bills paid without an overdraft, while at the same time earning good interest on my money and not worrying about moving money back and forth. That’s hard to beat.