Cash-Strapped Americans Can't Break the Overdraft Habit

Overdraft fees are like a movie monster that just won't die. No amount of public outrage or regulation can slay the beast.

But the banks aren't the only ones casting overdrafts in financial sequels: Truth is, consumers who don't properly manage their accounts, or who have money problems, keep breathing life into the overdraft dragon.

"Overdrafts are part of the small advance and loan market," explains G. Michael Moebs, CEO of Moebs Services. Other parts of that "market" include credit card cash advances, transfers from deposit accounts or small lines of credit, payday loans, pawn loans, even gifts and loans from family and friends -- and at the extreme, loan sharks. "The surprise is, no matter how much government tries to regulate and legislate away this small loan market, it keeps coming back," says Moebs. "People want and need a funding safety net."

According to Moebs Services, a consulting firm for the banking industry, overdraft revenue in the second quarter of 2011 was up b $700 million (from $30.1 billion in the first quarter to $30.8 billion) at both banks and credit unions. The average number of overdrafts per household remained fairly even.

In the majority of cases, overdrafts are accidents, something that happens when people don't keep track of their transactions. However, a surprisingly large fraction -- 26%, according to Moebs -- are intentional. The Moebs study found that 34 million Americans use overdrafts to fill a shortfall of funds, while 19 million of them go to payday lenders. "People have short term needs: medical, auto repairs, relative in trouble, or they are just short cash in some pay periods," says Moebs.

With median overdraft fees at $28, the cost of those accidents and choices adds up. Worse still, Moebs estimates that typically, 90% of overdraft fees are paid by the poorest 10% of customers.

The Pros and Cons of Overdrafts

Linda Sherry, director of National Priorities for Consumer Action, points out that there's more than one type of overdraft, and says the good and bad varieties of overdraft protection shouldn't be lumped together.

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"While overdrafts can serve as a short-term loan, we have some important caveats," she says. "We are not talking about 'automatic' overdraft or bounce protection. We are talking about the kind of overdraft protection that you apply for and it covers your overdrafts and charges you only a reasonable transaction fee and any interest on the loan. This one spares you overdraft fees altogether. Most reputable banks offer this."

"Banks also offer the kind of overdraft protection that we don't believe in -- when people overdraft they pay the overdraft but still charge a hefty overdraft fee of $30 or so. We urge caution in allowing a bank to do this," says Sherry.

Moebs argues though, that increased regulation of overdrafts does more harm than good. "Those Americans that rely on overdrafts and advance payday loans, do not have the FICO score to qualify for a line of credit or credit card," said Moebs, in a prepared statement. "By creating unintended consequences, such as predatory lending from loan sharks, adding limits to overdraft volume or price will do more harm than good."

"Regulators should get out of and stay out of the short term money needs of consumers -- they cause more problems than solutions. Instead of trying to tell consumers what they need and how to manage their money, let the market do it," says Moebs, whose clients include banking and savings institutions.

"The huge mistake that many make when looking at overdrafts, payday loans and pawn loans, is trying to measure it by large loan standards -- namely APR. It's like bringing a baseball speed gun used to measure the velocity of a pitch to measure the speed of a college or NFL football player. Overdrafts are measured by fee amounts, not rates."

Consumers Still Need Protection

Regulators clearly disagree with that: Overdraft fees remain high on their agenda. In 2009, the Federal Reserve stepped in with new rules to make overdrafts and fees more transparent. Since then, some banks have gone even further and eliminated the overdraft option on ATM and debit transactions. Other banking regulators have either proposed or issued supervisory guidance governing the banks that they oversee.

The newly formed Consumer Financial Protection Bureau, too, is taking on overdrafts. "The Bureau will carefully assess how we can best ensure that the overall market for short-term credit is fair, transparent, and competitive," said Raj Date, special advisor to the Secretary of the Treasury for the CFPB, in a recent speech at the Lessons Learned from the Financial Crisis: The Need for the CFPB event in Philadelphia. "We will be monitoring the impact of the recent regulatory and supervisory interventions. If we find that these interventions are not working as intended, we will adjust. And if we find that additional action is needed, we will act."

What's the best advice for consumers? Says Moebs, "Have your checking account at a community bank or credit union, because the price is less and you will get the short-[term] funding you need and want."