It’s Time to Protect Consumers and Regulate Overdraft Fees
“Oops! . . . I Did It Again” is both an iconic Britney Spears song and the thought that most likely pops into your head when you overdraft your checking account.
Research has found that you’re not alone and that most consumers who overdraft do so by mistake. It isn’t a surprise that banks have failed to help these customers: large banks earned over $6 billion in revenue from overdraft fees in 2022. They can do this because an anachronistic regulatory loophole exempts banks from providing disclosures and protections that are required for other types of consumer credit. Without these protections, it’s easy for consumers to keep making the same expensive mistake. To close the loophole, federal regulators need to step in.
High overdraft fees cause more than just a $35 charge when consumers inadvertently overdraft when debiting something as small as a cup of coffee. They can contribute to a perpetually low account balance. And failure to pay fees can sometimes lead to involuntary account closures that negatively affect credit scores, which in turn can block consumers out of the banking system. This dynamic can be especially harmful for low-income consumers, who are more likely to rely on overdrafting, which is — in a sense — a small loan or credit, but with a punishing interest rate. It’s true that, in recent years, some banks have reduced or eliminated overdraft fees. But many banks continue to profit from overdraft fees paid by consumers who can least afford it, often because consumers are not fully informed about the true cost of relying on overdraft credit.
Federal regulation could help. As part of President Biden’s war on junk fees, the Consumer Financial Protection Bureau (CFPB) has proposed a rule that could go a long way towards reducing the amount that consumers pay in overdraft fees (we submitted comments in support). Under the proposed rule, banks can choose to charge a much lower fee (either a default fee level set by CFPB or a fee that recoups only banks’ actual costs), thereby reducing the burden on consumers who mistakenly overdraft. Alternatively, if banks want to continue charging high fees, they must follow the same regulations that apply to other types of credit, which require more transparency and consumer protections.
Overdraft credit is essentially a short-term loan, but with an average annual interest rate of about 16,000%. Compare that to the typical 391% interest rate for the nefarious payday loan. Why would anyone agree to a loan on those terms? Consumers have to “opt-in” to overdraft coverage, but the fact that consumers rely on overdraft, often to cover purchases that cost less than the resulting overdraft fee, suggests a few possibilities. For one thing, they might not understand what they’re signing up for if the disclosures are confusing. And since they opt-in only once upon opening an account, they might not be thinking about the potential consequences of relying on overdraft credit when making purchases months or years down the road.
Another factor might be that consumers are overoptimistic about the situation. At the opt-in stage, they might (wrongly) believe that even though there are consequences to overdrafting, they won’t need to rely on it in the future. Or they might incorrectly assume that they have a high enough balance to cover a transaction. Even people who check their balance immediately before making a purchase might not have completely accurate information. In some instances, a previous transaction may not yet be reflected in their balance and so may unexpectedly draw money out of an account, leaving a balance insufficient for the present purchase.
Some people tend to value spending money today over saving that money to use in the future. This dynamic, called “myopia,” can lead to long-term consequences being outweighed by short-term benefits, when perhaps it should be the other way around, at least from a financial standpoint. Myopia can be exacerbated when consumers don’t have a complete picture of what the future consequences might be. If consumers are more focused on clearing a transaction today than on a possible overdraft fee tomorrow, they may not be able to accurately account for the full costs of the overdraft.
Consumers often don’t have the same knowledge that banks do about how certain overdraft credit products compare to others in the market. Some consumers do rely on overdraft credit intentionally, and these consumers are entitled to receive clearer, more salient information that will allow them to effectively make informed decisions. CFPB’s additional disclosure requirements can help consumers make the comparisons they need to make.
Maybe it would help to have a mobile banking app feature that warns a consumer when they’ve authorized a transaction that will cause them to overdraft. But banks haven’t implemented that technology, and consumers shouldn’t have to wait for it. Banks have long claimed that overdraft fees are a convenience, but they’re “not that innocent.” Regulation is needed to stop banks from continuing to profit from consumer mistakes.
