Since new banking regulations put a squeeze on services, like lending, that were once more profitable, overdraft fees have been a major source of revenue for banks and credit unions.

Last year alone, the country’s big consumer banks collected over $10 billion in overdraft fees.

The drive for profit has inspired some institutions to engage in overdraft fee practices suspect enough to get the attention of banking regulators. Now the regulators have proposed to draft new regulations limiting overdraft fee practices.

While some of the bank’s practices may not yet be considered illegal, a closer look at the ways some financial institutions impose those fees reveals practices that may run afoul of overdraft fee laws.

What is Overdraft Protection?

Financial institutions offer overdraft protection to cover checking account drafts that would otherwise overdraw the account – a situation also known as a non-sufficient funds transaction, or NSF.

With overdraft protection, the bank covers the draft using either a credit card, a line of credit, or a linked savings account.

The bank can charge the customer a fee for each covered transaction. These overdraft fees run around $10 to $35, depending on the institution. They’re often comparable to the fees charged for an NSF transaction.

The difference that may make overdraft protection worthwhile is that it allows the transaction to be paid, whereas in an NSF transaction, the customer’s bank refuses to pay the draft.

Paying the draft allows the customer to avoid other problems associated with NSF transactions, like fees charged by the party to whom the check was addressed. Bounced checks may also be reported to ChexSystems, which works something like a credit record for check writers.

Trouble can happen, however, when customers don’t fully understand their bank’s overdraft protection policies.

New overdraft fee laws put in place after the 2008 financial crisis have required banks to more clearly disclose their overdraft protection policies.

Since 2010, banks have been required to give customers a choice of whether to submit to overdraft fees or have the bank decline the draft. But consumer advocates say these fees still catch some customers off guard.

Protection that draws on a line of credit works like an automatic loan, and the interest charged may be unusually high.

If the customer doesn’t quickly pay off the fee, principal and interest, the interest can quickly drive up the debt amount, trapping the customer in what consumer advocates often describe as a “cycle of debt.”

In one particularly notorious practice known as reordering, a bank may pay drafts not in the order in which they were written but in order from largest dollar amount to smallest.

If a particular series of drafts would deplete the account, paying the largest drafts first makes that happen sooner, so that more subsequent drafts will trigger overdraft fees.

In 2009, reordering was the subject of a series of class action lawsuits against more than a dozen major banks.

New Regulations for Overdraft Fees

Fortunately, the Consumer Financial Protection Bureau is on the case. The agency has been thoroughly studying practices like reordering in order to draft new overdraft fee laws that will hopefully make things better for bank customers.  Hidden costs and confusing terms may soon be a thing of the past.

The formal rulemaking process is expected to begin sometime later this year.

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