Why banks' overdraft offers are a bad deal

I was glad to see this week that the Federal Reserve has started to limit banks' ability to charge overdraft fees to debit-card users if the banks approve purchases or ATM withdrawals that push cardholders into the red. 

Starting July 1 for new customers, and starting Aug. 15 for existing account-holders, banks can only impose such fees if they get your permission beforehand. (Click here to see the Fed's guide to the new rules.) If you haven't already, you'll likely soon be getting an offer from your bank - an offer that, in my opinion, is a trap worth avoiding. Some context will help explain why. (You can also read my column in Sunday's Inquirer, "Just say NO to 'standard overdraft practices'")

Over the last decade, banks have increasingly muddied the distinction between debit cards and credit cards, and have turned debit cards into a highly profitable vehicle for making flat-fee loans to people who are either financially stressed, too inexperienced to recognize the risk, or too harried or disorganized to pay close attention to their balances. In hindsight, most of those people would have rather heard the words "Your transaction was declined." But banks made so much money from debit-card overdraft fees - more than $11 billion last year, according to consumer advocates - that they were all too happy to approve the transactions.

The Fed, while insisting that OK'd overdrafts are not loans, finally decided there was enough evidence of consumer harm to act. And now even a handful of bankers are conceding it wasn't the best idea.

As I reported in an article Thursday,  two of the nation's largest banks, Citibank and Bank of America, have decided not to ask customers to opt into what had previously been their "standard overdraft practices," in the Fed's jargon. "This is really a result of listening to our customers, the vast majority of whom have said they don't want to spend money that is not in their account," a Bank of America spokesman told me.

But others, including Philadelphia's largest banks, are inviting consumers to "opt in."  Barb Mealmaker, a senior vice president at Citizens Bank, said about half of the bank's customers are choosing to end their exposure to these overdraft fees. The other half are opting in, she says, because they welcome the emergency protection against having a transaction declined "with a cartful of groceries, or if they have a car emergency."

Nearly every discussion of these fees raises the same questions about the boundaries between individual responsibility and regulatory intervention. As one of my editors asked, "Where does personal responsibility kick in?"

It's a fair question, and one I've been asked periodically over the years - I've been writing about this issue, believe it or not, since 2002. Others include:  "Why worry about people who are too sloppy to watch their bank balances more carefully?" and  "Aren't they just getting what they deserve?"

The short answer is that customers clearly bear primary responsibility for their own finances - that's how our system works. But that doesn't mean they aren't susceptible to traps set, intentionally or not, by banks or other businesses - nor does it absolve regulators from watching for patterns in the marketplace and intervening when consumers are suffering undue harm.

I've written, as have journalists around the country, about people who faced hundreds or even thousands of dollars in overdraft charges, sometimes for single mistake, such as not understanding they faced a long hold on a deposit before making a series of small purchases with a debit card.  Sometimes, an initial set of overdraft charges pushed them deeper into the red and resulted in a cascade of additional overdrafts.

Could they have avoided the problem by paying closer attention to their balances? Often that was true, but not always.  Last fall, Benjamin Cohen - who had already asked his bank to refuse debit-card overdrafts - got socked apparently because two bank computer systems weren't fully in synch. The charges were imposed even though his father was online monitoring his balance and, at Cohen's request, transferring funds into his account expressly to avoid the charges. (Click here to read Cohen's story.)

Under the new rules, a customer who has opted out can't be charged an overdraft fee if the bank mistakenly approves a debit-card or ATM overdraft. I'm willing to wager that if they're on the hook, banks will figure out better ways of making sure that unwanted overdrafts don't go through. (One exception, by the way, is that the new rules don't apply to overdrafts generated by preauthorized recurrent payments - or old-fashioned checks.)

It's clearly risky to use a debit card when your balance might be pushed into negative territory. But as the cards are used at more and more places for smaller and smaller purchases, it's unrealistic to expect that harried consumers are going to carefully pull out a check register and record each use. That's why so many will benefit if charges that would put them in the red are simply declined. 

People who are genuinely credit-worthy should have other, better alternatives - credit cards, for one. They'll also probably qualify for their banks' alternative "overdraft protection plans," which transfer funds, typically for a smaller fee, from a savings or credit account. Those who don't qualify for one of those alternatives, and who choose to accept their bank's standard overdraft offers, risk just digging themselves in deeper financially if they use overdrafts beyond a rare emergency.

The Cohen case and that of the first customer I wrote about back in '02, Juanita Wooten, are a reasonable illustration  of who is most at risk here: the young and the financially stressed.  But Wooten's story (click here to read it) encapsulates the issue, because she quickly identified what her bank, a Wachovia predecessor, was doing that from her standpoint wasn't quite right or reasonable.

Wooten was a woman on a fixed income who had gotten into trouble with credit in the past, so she forswore credit cards - in large part because she knew she couldn't afford to pay interest. "I got in trouble, and that was the end of that," Wooten said back then. "Since that time, I pay cash or lay it away."

But then her bank introduced a new, convenient method of paying with plastic - a Visa Check Card - and told her it was simply like paying with an online check, using her own money directly from her bank account.

What the bank didn't tell her, and what she discovered the hard way, was that this Visa card wasn't completely unlike the credit card she had cut up.  Her bank was happy to let her spend beyond her means: When her balance fell short, it advanced her a little cash and then charged her for it.

If that's not extending credit, I don't know what is.

Ultimately, Wooten's bank offered her the option of having her overdraft limit set to zero, so that further in-the-red transactions would be declined.  Making that the default option for everybody was the right thing for the Fed to do.