Debit cards are often promoted as a cheap alternative to credit cards. While this can be true in many cases, overdraft fees from the associated account can be a trap for the unwary if they are not watched with reasonably care.
Debit cards are seen as a cheap alternative to credit cards for a number of reasons. Firstly they are a good method of making purchases over the internet and the phone as they use the same payment processing system as credit cards. They can also be used abroad and are accepted in the same places as credit cards.
As a debit card accesses an associated bank account, usually a transaction account but also some home loans and savings accounts, the interest rate is considerably lower than that of most credit cards. However, incautious use of a debit card can lead to overdraft penalty fees, which can rise to startling levels in a short period of time.
Overdraft penalties are charged to an account holder who overdraws the debit card’s associated transaction account overdraft limit, or has no agreed overdraft for the account in the first place. The penalty fee can be either a flat fee or a fee that is charged every day the overdraft limit is breached. This can be a considerable “interest rate” charged against a “short-term loan.”
For example, if an account carries an agreed overdraft limit of $1,000 and the current overdraft is $900, if there is a $300 charge on the card then the overdraft will be $1,200, or $200 over the limit. At this point the penalty will be activated. If the penalty is $20 and the overdraft only lasts a week, then there is an effective interest rate on this $200 of 10% for the week, although on an annualised basis this would be an interest rate of 14,430% (144 times the amount borrowed).
There can also be penalty rates of interest that are charged to the transaction account which may be higher than the rate charged to the overdraft.
Transaction accounts can be particularly susceptible to this because they are likely to have a number of direct debits and recurring fees drawing from the account. For this reason it’s a good idea to have an email or text alert sent to the account holder if the bank offers such a service. These alerts will allow an account holder to know if they are getting close to the overdraft limit before the balance tips over.
