A costly courtesy: overdraft privilege

Besides being illegal, bouncing a check is costly. Customers face combined charges from banks and retailers that often total $60 or more.

In recent years, banks have helped customers avoid such consequences by offering overdraft protection - and, more recently, overdraft privilege - selectively covering checks that would otherwise bounce.

But some consumer groups say more recent versions of this program encourage customers to overdraw their checking accounts, generating millions of dollars in fees for banks. More than 1,000 banks offer some variation of overdraft privilege. Many banks also allow customers to overdraw accounts with ATM and debit-card transactions.

Banks contend that these services help customers avoid embarrassment, bad credit ratings, and returned-check fees from retailers. But critics view these programs as mere profit-generators for banks, often forcing customers into the equivalent of high-interest loans.

"Many of these programs encourage you to borrow money from the bank without disclosing the costs or setting up a reasonable repayment schedule," says Jean Ann Fox, director of consumer protection for the Consumer Federation of America. "Often, it's not even something that customers agree to. It's an automatic courtesy extended by the bank."

Consumer groups are urging the Federal Reserve to stop banks from providing overdraft privilege unless they abide by "truth in lending" laws and have a customer's written consent.

"If the Fed doesn't rein in it, then there are going to be big problems," says John Caskey, an economics professor and banking expert at Swarthmore College in Swarthmore, Pa.

Overdraft privilege was introduced in the mid-1990s and marked a major shift in the banking industry. While overdraft lines of credit had long been offered to favored customers, these newer programs target customers living from paycheck to paycheck. Overdraft fees are more expensive and restrictive than those charged to wealthy customers. While some programs charge a single flat fee of $25 to $35 for each overdraft, other banks impose daily fees until the account balance is out of the red. These fees can exceed what amounts to a 1,000 percent loan on lines of credit of up to $1,000. As such, overdrafts have become an attractive source of profit for banks.

One consultant estimates banks can increase nonsufficient funds (NSF) income by 50 to 200 percent by offering these programs. "Bankers are looking for noninterest income to strengthen their bottom lines in this soft economy, where lending has been reduced and profit margins have almost disappeared," says John Floyd, chief executive of John M. Floyd & Associates, an overdraft-privilege programs vendor in Baytown, Texas.

Some banks market the programs via brochures or on websites, reassuring customers that bounced checks will be covered. The fine print typically reserves the right not to pay a check, skirting any "truth in lending" issues.

For example, FirstBank in Kansas tells customers who have made honest mistakes in their checkbooks, run a little short on cash, or are faced with unexpected expenses to "relax... you deserve consideration." Wainwright Bank in Massachusetts uses the exact same language. But neither bank discloses the fees it charges for covering a bounced check, nor would bank officials return calls seeking comment.

But Diane Casey-Landry, the president of America's Community Bankers in Washington, D.C., insists that full disclosure is made to consumers and that ignorance of the rules is no excuse.

"If a bank sends you a letter telling you that it has changed your account, then it has given you all the disclosures and notifications and done its job," says Ms. Casey-Landry. "Customers have a responsibility to read the correspondence that comes from the bank."

But scorned customers, including consumer lawyer Catherine Harlow, claim they were automatically enrolled for overdraft privilege programs without any notification. Ms. Harlow transferred $1,000 from her savings account to her checking account at KeyBank in Cleveland. The bank later informed her by mail that the funds were not available, but it had credited her account as a courtesy. "They charged me $30 for the courtesy, as they called it, and I had to pay that $1,000 back within five days or I would have more fees," says Ms. Harlow.

KeyBank's fee schedule states that if an account remains overdrawn for five consecutive business days, customers will be assessed a "recurring overdraft service charge of $27.50 and will be charged $27.50 once every five business days thereafter until [the] account balance becomes positive, including the payment of all outstanding fees or until the account is closed."

Harlow persisted with bank supervisors until the fees were reversed. But the situation was much more serious for Scharlotta Gardner, a retired cook from Lewisburg, W.V. who lives on a fixed income of less than $600 a month. Ms. Gardner banked with City National Bank of West Virginia and its predecessors for more than 30 years when she mistakenly overdrew her account in 2001. By the time she was aware of the bad check, she had racked up $125 in fees.

"They were charging me five dollars a day in fees. That's a lot of money to me," says Ms. Gardner. "I was short of grocery money and everything else. After you pay utilities and things out of $565 there's not a lot left."

Ms. Gardner borrowed money from a friend to avoid additional fees and has filed suit against the City National. Officials from the bank did not return calls seeking comment. But the bank has since changed its policy, says Joe Gillen, chief executive of Pinnacle Financial Strategies, in Houston.

Mr. Gillen says the bank has adopted Pinnacle's Bounce Protection program, which charges customers one NSF fee and nothing more. If customers cannot bring their balance back into the black, then they can make arrangements with the bank to pay it back in installments - with no additional fees.

"I wouldn't operate the program any other way," says Mr. Gillen, who advocates for more regulations for overdraft privilege programs. "Banks may make some bucks short-term that way, but it's not good business long-term."

Before opening a checking account, consumers should know the difference between overdraft protection and privilege.

Overdraft protection programs typically transfer funds from other accounts or a credit card to your checking account when its balance falls below zero.

On the other hand, overdraft-privilege plans use cash made available by the bank to cover checks that would otherwise bounce. Rules vary from bank to bank, with some advancing only $100 while others extend as much as $1,000.

Fees and payback terms also vary. Some banks charge only a NSF fee and let customers pay back the extension on a monthly basis. But more often, banks require the account be brought back into balance within days or weeks or customers run the risk of additional charges. Still others charge a daily fee until the account is out of the red.

Experts recommend asking your bank specific questions to avoid costly confusion about overdraft programs. Some points to consider before opening an account:

• See if the program debits other accounts (savings, credit cards) for overdrafts, or if it's a "courtesy" program, involving fees for insufficient funds. You should be able to opt out of such courtesy programs.

• Find out if the bank adds the overdraft limit into your account balance. For example, you may only have $200 in the bank, but an ATM slip may say you have $1,200, accounting for $1,000 in overdraft wiggle room. Not knowing this may lead customers to make unintentional overdrafts and incur additional fees.

• Determine whether the bank automatically taps into your overdraft limits on debit card purchases without your consent. If it does, you may unintentionally spend more than you have.

• Ask if your bank covers large checks first before covering small checks. This practice can result in more bounced-check fees.