Where do overdraft fees come from?

The first overdraft fee was implemented in 1728. At the time, it was great for small and large businesses alike. Then things changed.

Overlooking Edinburgh, Scotland

No one likes bank fees, yet they seem unavoidable. Of course, they’re not—we’ll get to that—but given the poor incentives of the modern banking system, it’s no surprise that every action we take seems to drain money from our account.

In 2020, the average American paid $7 in bank fees every month. This might not sound like much, but consider the fact that banks charged over $4.1 billion in non-sufficient funds fees and $5.1 billion in overdraft fees in just the second quarter of that year. Overall, in the first three months of the COVID-19 pandemic, banks pulled in roughly $11.6 billion in fees—at just the time Americans needed money most.

As with interchange fees, small numbers add up quickly. As GOBankingRates frames the issue,

If you avoided that $7 monthly fee and instead put it into a savings account with an annual percentage yield of 0.09%, that would add up to an additional $91 in savings each year. Over 50 years, that would amount to $4,303.25 if the money had been deposited in an average savings account — or an even higher $4,843.46 with a high-interest savings account that has a 0.50% annual percentage yield.

Eye-opening, certainly; then you realize that 0.50% isn’t even a great APY. How about the same amount of money being saved in an account with 5% APY rewards? Over one year, that’s $93.49, but then look at the long haul: in 50 years, you’d have $18,868.30, roughly four times the highest number listed above.

That’s what bank fees take from us. Let’s see how these fees came to be—specifically, the overdraft fee, one of the most insidious fees around. Then, in an upcoming post, we’ll look at what you can do about these fees.

Bank vault

A brief history of overdraft

William Hogg had a problem. The Scottish merchant wasn’t being paid in a timely manner, though by his account, he was paying his suppliers right away. The fluctuations in his bank account caused his stomach to churn. So he approached the Royal Bank of Scotland to find a solution.

Together, they invented the overdraft fee.

In 1728, his bank created the world’s first overdraft facility. Within a few decades, numerous UK-based banks adopted the practice. From there, it became a global practice. While it started off with the best of intentions, over time consumers have had to fight bank fees even as they’ve grown more expensive year after year, century after century.

On the face of it, the fee made business sense: the bank says we know you’ll eventually pay your bills, so we’re going to front you the money for a small fee. This allowed Hogg to stay cash-positive and pay his suppliers on time, while the bank earned a bit for those in need of a cash credit.

In the early days, overdraft fees helped struggling businesses stay afloat. Even more importantly, it injected needed capital into new businesses. Incredibly, only two men were needed to vouch for the founder in order for them to receive this cash credit. (Business was much more local at this time).

Banking skeptic and noted philosopher David Hume appreciated the expansion of commerce in his native Scotland that the overdraft fee provided, stating that it was “one of the most ingenious ideas that has been executed in commerce.”

So overdraft fees were invented to solve a business problem—and it worked, for some time, at least. Merchants could keep their accounts out of the red by forcing customers to pony up a few extra dollars if they were late. Start-up founders secured early investment in their company provided a few friends vouched for their ability to pay.

Over time, however, banks realized this could be used as a tool to maximize profits from individual customers.

That’s when things went south.

Piggy bank

Hitting where it hurts most

Today, a typical overdraft fee is $35. In 2021, banks pulled in a whopping $15 billion from customers with less than $350 in their accounts—customers least likely to be able to afford such fees in the first place. Incredibly, 75% of overdraft fees are charged to consumers accumulating over 10 overdraft fees per year. That means they’re paying roughly the total amount of money in their account in fees, then have to make up for it just to get their balance above zero every month.

The frustration compounds when considering that some banks apparently reorder transactions so that customers get hit with overdraft fees:

One such practice is commingling of all checks, bill payments, debit card transactions, and ATM withdrawals each day and processing the largest transactions first. This maximizes the number of transactions that will trigger an overdraft fee.

The evolution of overdraft fees, from capital injection to established businesses and start-ups to a profit maximization tool that intentionally harms the customers least likely to be able to afford such fees, is a chilling example of incentives gone wrong.

Thankfully, technology now offers us better solutions with customer-centric incentives. Next week, we’ll look at how to combat these fees.


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