The (overdraft) protection racket

"We're willing to offer protection - for a fee. But if you want it, you'll have to sign up." That's the message many banks and credit unions are sending to their debit-card customers, as implementation nears for new Federal Reserve rules (PDF) on debit card overdrafts. You may be told that you will lose "important protections" or "a valuable safeguard" if you don't opt in.

Below is a snippet of the letter I received from my bank late last week.

MarketWatch's Chuck Jaffe has the background on what this is all about:

[Under current rules,] if someone present[s a debit] card against insufficient funds, [most banks will] make good on the transaction, put the account into the negative and tack on a fee of up to $40, putting the account further into the red....

All told, banks collected $38.5 billion in this type of overdraft fee alone in 2009, according to Moebs Services, a Chicago-based bank-industry consulting firm.

Under the Federal Reserve's new rules - which go into effect July 1 on new accounts and August 15 for existing customers - banks can only charge an overdraft fee on ATM and debit transactions if they first get customers to opt in to overdraft services.

If you don't opt in - and don't arrange for one of your accounts to back up another - and there's not enough in the account to cover a transaction, and you try to use your card against an inadequate balance, the purchase or withdrawal will be declined.

Sure, it's no fun being told that your card won't be accepted, but are you willing to shell out $30 or more to avoid embarrassment? Besides getting rejected might push you to get serious about the tasks of documenting your spending and balancing your checkbook.

"For many people, an overdraft is something accidental, where they haven't reconciled the account or recognized that their spouse just went out and bought something on another debit card linked to the account," said Gerri Detweiler, author of The Ultimate Credit Handbook....

"I just don't think that saving face with a clerk is worth 35 or 40 bucks a pop," Detweiler said.

Jaffe also quotes Greg McBride, senior financial analyst for BankRate.com: "Nothing will ever solve this problem better than knowing your balance and simply managing your spending so that overdrafts are never a problem." Amen.

By the way, recurring debit-card transactions - i.e., auto drafts for regular bills, such as a mortgage payment - are exempt from the new rules. If you overdraw, the bank will cover the transaction - and, of course, you'll pay a fee.

For a quick primer on debit cards (including some significant downsides of using one), see Mary Hunt's article, "What You Need to Know About Debit Cards," in the current issue of the Sound Mind Investing newsletter.

Update: The overwhelming majority of checking-account holders never overdraft their accounts, according to the FDIC. Most overdrafts are concentrated among about 14% of users (see graph).

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Joseph Slife is a contributing author and editor for SMI. Learn more about Christian investing and finances at the Sound Mind Investing website.