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Overdraft protection: A trap you didn’t see coming

Payday loans have a bad rap. If the flashy storefronts and tacky, overly exuberant ads don't make you think twice, the interest rates should — they're often more than 20 percent of the amount borrowed.

And yet there's another high-interest loan you may be blindly paying — without even hitting a tattered strip mall to get it. We're talking about overdraft protection, and while its name implies benefits, this loan comes at a cost that's much too steep, especially when there are so many other options.

[If your bank were a celebrity, who would it be?]

So why should you avoid overdraft? And, more importantly, how can you avoid running into insufficient funds without taking the financial hit? Let's find out...

A huge financial pitfall

There's nothing more embarrassing than hauling a pile of goodies up to the cash register only to have the gum-chewing cashier loudly declare that your account is overdrawn. But emptying your bank account has repercussions that go beyond mere ego: most banks charge hefty fees for bounced checks. You may also face fees and late charges for any bills that go unpaid as a result.

Overdraft protection aims to come to the rescue in these situations by sweeping in and picking up the tab whenever you miscalculate your bank balance. Sounds great, right?

[More: Payday loans: the energizer bunny of debt]

Unfortunately, the price of peace of mind is just too steep. Indeed, overdraft protection generally entails a monthly fee. Furthermore, when you do go into overdraft, you'll pay a fee of at least $5 and be subject to an interest rate of at least 20 percent. That's worse than the average credit card!

No overdraft, no problem

Although figures from Statistics Canada show that Canadians spend relatively little on bank fees, if you're using overdraft regularly, you're definitely putting yourself at the wrong end of the bell curve. And while running up against bounced checks and insufficient funds certainly aren't viable options, there are some things you can do to avoid what debt expert and financial advisor, Stephanie Holmes-Winton, calls the "rich man's payday loan."

1) Take the hint

A cash crisis can occasionally happen to even the best budgeters, but if you're overdrafting on a regular basis, you have a problem...and it very likely involves (over)spending. The good news is that most banks these days allow depositors to access up-to-the-minute account details at any time from anywhere, whether by phone or over the Web.

[More: Bank account basics: How to choose the right account for you]

Repeated use of overdraft is a sign that you aren't tracking your expenses as closely as you should. If running out of money is something you struggle with, set up accounting software — or even just a good old spreadsheet — and track every expense. Once you know what's sinking your budget, it's time to do something about it.

2) Maintain a minimum monthly balance

Many banks offer a premium checking account that will waive all banking fees if you maintain a minimum monthly balance, usually $1,000 to $2,000. That's a lot of money, but when you consider that we spend an average of $185 per year on bank fees, it's actually a pretty good (not to mention guaranteed) return in investing terms. Plus, if you happen to blow your budget on occasion, it'll only cost you the regular bank fees for that month, rather than all the overdraft charges. If you keep an even bigger cushion, you can virtually wipe bank fees right out of your budget. (And if having a nice wad of cash in your account doesn't make you feel smug, saving more of it should do the trick!)

3) Use your savings

Now let's just start by saying that we do not advocate that people dip into their savings whenever the mood strikes. That said, using a savings account as a sort of bridge financing from time to time is better than the alternative. Plus, if it happens rarely, you're probably dealing with a true, unforeseen financial emergency. This is what your mom might call a rainy day, and while no one likes getting wet, using overdraft to cover yourself is like buying a brand-new designer rain jacket to shield you from the storm, rather than pulling out your trusty old umbrella.

[More: How to say goodbye to chequing fees for good]

4) Carry cash

Cash — of the physical kind — is becoming increasingly rare these days, but it does have one major benefit for those who struggle with overspending: once it runs out, that's it - finito, no more shopping! It sounds harsh, but for some people, that physical reminder is exactly what it takes to slow them down before they hit bottom. And that's precisely why budgeting experts often recommend the envelope system for those who are new to budgeting and need to get their spending on track.

The system is simple: start by labelling several envelopes and filling them with enough cash to cover your major expenses. You can even have one just for frivolous spending and fun. The trick is to make this cash last the whole month. Unlike with your debit card, you won't have any excuse to be surprised when there's nothing left; you will have doled out every last bill yourself.

5) Ask to opt out

It wasn't so long ago that there was no such thing as overdraft protection. When people ran out of money, they just left the store and went home (yes, emptyhanded!). Now, many accounts offer overdraft automatically. Whether you have a tendency to flirt with broke each month or not, find out if your bank account includes overdraft protection. When you're ready, ask to have it removed.

Who is it protecting?

Overdraft is marketed as a form of protection, and while it is in some ways, it's really only protecting you from yourself. It's a bit like putting on a helmet before jumping off a cliff...yeah, it might reduce the damage, but it kind of misses the point.

GoldenGirlFinance.ca is a free personal finance and education site for women.

Nothing contained herein is intended to provide personalized financial, legal or tax advice. Before implementing any financial or legal strategy, you should obtain information and advice from your financial, legal and/or tax advisers who are fully aware of your individual circumstances, as well as fully aware of current laws and regulations.

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