06/21/2013 01:40 pm ET Updated Aug 20, 2013

Protection Racket: A Wake-Up Call on Overdraft Fees

It's a big moneymaker for banks. It's also a practice that Richard Cordray, director of the Consumer Financial Protection Bureau (CFPB), has said carries the potential to "inflict serious economic harm."

Banks refer to it as overdraft protection, but in the hands of some institutions, it might more accurately be referred to as a protection racket. The CFPB released a report this month that highlights the hazards of overdraft protection, and consumers who want to protect themselves would do well to make sure they understand these dangers.

The scope of the problem

Overdraft protection means that a bank will cover a customer's overdraft of a checking account, in exchange for a fee. In 2010, a new regulation made banks assume that customers did not want this service, unless they explicitly opted in for it. Despite that regulation, 22.3 percent of customers opening new checking accounts in 2011 opted in for overdraft protection, according to the CFPB report.

Because many customers are still opting in, overdraft fees remain a huge part of bank revenues. Estimates vary on the total amount of overdraft fees charged annually, but an industry analyst cited in the CFPB report indicates the figure tops $30 billion.

An unnecessary price for protection

You may view overdraft fees as a convenience, but research by indicates that average overdraft fees are around $30 per occurrence. If you make multiple transactions while your account is overdrawn, you could pay that $30 several times.

The CFPB found that customers who overdrew their accounts at least once paid an average of $225 per year in overdraft fees. To put that in perspective, at current savings account rates, you'd have to maintain a balance of $375,000 to earn enough interest to offset the overdraft fees in your checking account.

Possible solutions

What more can be done to prevent consumers from paying so much in overdraft fees? Here are some possible solutions:

  1. Legislation to restrict overdraft programs. Legislation could do anything from capping overdraft fees to banning them altogether. However, this would deny a form of service to some customers who really want it, and cost other customers more money as banks raise other fees to make up for lost overdraft revenues.
  2. Better disclosure. Opt-in rates vary greatly from one bank to another, so clearly banks are taking different approaches to pitching this service. A clear, standardized form of disclosure could normalize opt-in rates at all banks.
  3. More consumer vigilance. Consumers need to be more careful about what they agree to -- especially in the initial account sign-up process when a number of documents are being presented at once. Don't sign your name until you've read and understand every part of each document.
  4. Better banking habits. For some people, an overdraft is a rare mistake, but the CFPB found that more than a quarter of the accounts that had at least one overdraft had more than 10 over the course of a year. These customers need to develop better record-keeping habits to avoid overdrafts, rather than leaning on overdraft protection so heavily as a backstop.

It's not wrong for banks to make money from overdraft fees, and overdraft protection can be helpful in certain situations. However, the use of this protection is way too prevalent, and that's something consumers have the power to change without any help from banks or regulators.