Insufficient funds: How banking overdrafts are hurting Americans’ wallets

In 2022, Americans paid over $8 billion in fees as a result of bank overdrafts and insufficient funds (NSF). Some of this total includes “junk fees,” through which banks prey on unaware consumers.

But overdrafts and NSF are also a source of emergency credit for low-income consumers who cannot afford to miss an important payment. Prohibiting these fees may cause many consumers to lose access to utilities or other needed goods or services.

Better disclosure can help. Consumers should receive notification and the opportunity to approve every transaction that results in a fee. This notification and approval process is already in place for ATM fees. It should be extended to overdraft and NSF fees.

Overdraft and NSF fees are a logical result of the interaction between bank-account economics, consumer psychology and consumer needs. The annual cost to a bank of maintaining a deposit account is a few hundred dollars, so banks must earn this back in revenue.

Banks earn revenue on deposit accounts in essentially two ways. On large accounts, banks collect interest and cross-sell credit or investment products. For low-balance accounts, banks charge checking and especially overdraft and NSF fees. Bank accounts with low or no monthly checking fees represent a type of teaser rate. The account is nominally free, but banks know they will make profits through overdraft and NSF fees.

Around 10 percent of Americans pay an overdraft fee annually; this group is disproportionately likely to be young, low-income and from a minority group. Accounts that incur more than 10 overdrafts or NSF a year are responsible for almost 80 percent of all fees.

On the one hand, the evidence strongly suggests that this fee model preys on consumer psychology. Almost 70 percent of the consumers who have experienced an overdraft or NSF would have preferred that the transaction be declined — in other words, most consumers are paying for a service that they don’t even want.

Consistent with this view, the median transaction amount that causes an overdraft or NSF fee is around $35, which is also close to the amount of the typical fee. It is hard to believe that most consumers — if they were aware of the charge — would agree to a $35 fee on a $35 transaction. For example, if a consumer pays the fee in seven days, it is equivalent to a short-term loan with an APR of over 5,000%.

On the other hand, many consumers appear to understand that they are using overdrafts and NSF as a form of credit. Just over half of consumers who have experienced an overdraft or NSF used them to guarantee a payment when they might not have had enough funds. Prohibiting overdrafts would deprive many consumers of an expensive but possibly necessary form of credit.

Overdraft fees have been regulated through an opt-in provision since 2009, but with limited success. Under current law, financial institutions may not charge overdraft fees — incurred through use of a debit card — unless a consumer expressly opts into overdraft protection. However, a 2017 study found that nearly 63 percent of overdrafters were unaware of this right.

In 2022, the CFPB issued further guidance that surprise overdraft fees — where the bank charges a fee even though the consumer appears to have a positive balance — violate existing law. The CFPB issued similar guidance for fees charged by banks when a depositor deposits a check that bounces.

These actions, along with public scrutiny and criticism of large banks that rely on overdraft and NSF fees, have reduced total fees, but $8 billion a year is still a lot of money.

Smarter disclosure modeled on the requirements for ATM fees would help. Regulators should require that banks disclose, on a per transaction basis, the amount of the overdraft or NSF fee that would be charged as part of the transaction. Consumers who would otherwise have been unaware of their bank balance can decline the transaction, while those who need to make a payment can approve it.

Millions of Americans live one purchase away from emptying their bank account, and they pay a steep price for oversights in account management. Better regulation can stop banks from preying on consumer inattention so that overdrafts and NSF can truly function as a means of emergency credit, at least until better options emerge.

Prasad Krishnamurthy is a professor of law at U.C. Berkeley School of Law.