Editorial Policy

Study: Overdraft Fees Don’t Deter Cardholders

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By Eva Norlyk Smith, Ph.D.
March 24, 2011

Overdraft fees on credit and debit cards have long been a hotly debated issue. Consumer advocates heralded it as a major legislative victory when banks were barred from charging overdraft fees on debit cards and credit cards unless consumers opted in. In the case of debit cards, however, the new rules appear to have a limited effect.

According to research by Moebs Services, the majority of debit card users have opted in for overdraft protection, surprising observers who expected the opposite to occur. Before the new federal regulations were put in place last year, a full 80 percent of debit cardholders surveyed said they didn’t want the protection.

But despite the regulations, as many as 100 million U.S. checking account holders are still liable for overdraft fees, says Moebs Services. Banks, in turn, are projected to rake in $38.5 billion in overdraft fees in 2011, $2 billion more than the $36.5 charged in 2010.

Overdraft protection used to work like this: Unless you explicitly stated otherwise, you were charged a fee of $35 whenever you overdrew your account. This meant that many consumers unwittingly wound up paying a huge fee, even if they only made a small purchase. A debit card charge of $3 causing an overdraft, for example, could end up costing a consumer $38 in charges! With the new legislation, however, account holders have to opt in and agree to the overdraft terms, presumably leaving them fully aware of the costs.

At the time, economists estimated that once the new law kicked in, most account holders would choose to opt out of overdraft protection in order to avoid the high fees. However, the opposite has happened: The estimated number of people who have opted in is close to 75 percent, and some banks have opt-in rates as high as 90 percent.

So what gives? Why would the majority of debit cardholders opt in for an expensive service that offers few advantages? After all, wouldn’t you rather have the charge for that $2.99 latte declined — alerting you to the fact that your account is out of money — rather than pay a $35 fee to have it covered?

The answer, it appears, may lie in a combination of clever marketing and short-term financial need. Many banks have aggressively marketed debit card overdraft protection to their account holders, and most have succeeded in making overdraft protection sound like a plus.

Secondly, many of those opting in for overdraft protection are the ones who can afford it least:  Low-income consumers. A whopping 93 percent of all overdraft fees are paid by just 14 percent of bank customers. And low-income consumers who can least afford the fees are footing the bill for the vast majority of those fees. Indeed, the number of low-income bank customers who opt in for overdraft protection is estimated at close to 98 percent.

Experts say that low-income consumers are often less financially savvy and more easily swayed by banks’ aggressive marketing campaigns. And, in many cases, they may also feel they prefer having recourse to a short-term loan, should they need extra funds to carry them over to the next paycheck. Unfortunately, few realize that they pay dearly for that short-term loan. According to Bankrate.com, paying a $27 fee for keeping a $20 overdraft for two weeks amounts to paying an annualized interest rate of 3,520 percent on that short-term loan.

On the bright side, when it comes to credit card over-the-limit protection (the equivalent of debit card overdraft protection for credit cards) the legislation — introduced by the Credit CARD Act of 2009 — appears to have been successful. The new rules for credit cards are similar to those for debit cards: Cardholders can no longer be charged over-the-limit fees unless they explicitly opt in for over-the-limit protection. But they have had a much greater impact on consumer behavior.

According to recent studies by the Office of the Comptroller of Currency and the Consumer Financial Protection Bureau, the number of credit card accounts incurring a late fee decreased from an average of 12 percent a year to just 1 percent of accounts after major provisions of the Credit CARD Act were enacted. In fact, many card issuers have decided to simply waive the over-the-limit fee, but still allow overdrafts for cardholders in good standing.

Why the difference in the effect of overdraft protection rules for debit cards and credit cards? One can only speculate; but again, the overdraft protection on debit cards may seem more advantageous to low-income consumers or people with bad credit. These consumers may be less financially savvy than others and may also be less likely to have access to the credit cushion afforded by credit cards.