Laura Rowley Money & Happiness

Ever use your debit card and overdraw your checking account, only to later discover that the bank lent you the money -- at a fee -- to cover the overdraft?

Do the math. You may find that you paid an effective 3,000 percent annual interest rate on a courtesy loan you never asked for.

Electronic Loan Sharking

Consumer advocates have been calling on financial institutions to address abusive overdraft practices for several years, and now Congress is poised to act.

"I don't know what loan sharks are charging these days, but these rates are probably a bit higher," says Eric Halperin, director of the Washington office of the Center for Responsible Lending (CRL). "They're more expensive than any other financial product out there."

In the old days, banks would deny a check payment if you didn't have adequate funds in your account, and charge a bounced-check fee. The only way to avoid this (both then and now) was to have a backup -- a link to a savings account or line of credit. If overdrafts became too frequent, the bank would close your account.

Fee Overload

Today, debit and other electronic transactions are the dominant form of payment. Rather than deny payment, most banks automatically cover your small-dollar overdraft and slap you with a fee averaging $34 on every subsequent transaction until your account is back in the black.

A CRL study released this month found consumers pay $17.5 billion in fees on abusive overdraft loans. The average overdraft is just $27, and is typically repaid within five days.

"In 2004, 80 percent of banks routinely declined overdrafts," says Halperin. "Today, 14 of the 15 largest banks routinely cover overdrafts. It indicates a dramatic shift in the marketplace." The Federal Reserve allows banks to enroll consumers in overdraft protection programs without their written consent.

Shady Practices

Moreover, banks can legally manipulate the order in which they pay checks and debits to maximize fees. Consider this example: Bob thinks he has $1,300 in his checking account, but he only has $1,150. He conducts six debit transactions totaling $180, and then pays his rent, for $1,100. He's overdrawn the account by $130.

Bob's transactions arrive in one batch at the bank. Instead of paying the six transactions and charging a single overdraft fee on the rent check, the bank pays the rent check first, followed by one transaction for $50. It then provides overdraft loans for the other five payments, so Bob incurs five separate fees of $34 each -- or $170. (Banks reserve the right to pay checks in any order; see, for example, the policy of U.S. Bank.)

Two weeks later, Bob deposits his paycheck, and the bank gets its money back. Bottom line: When Bob pays $170 for a two-week loan of $130, the annual percentage rate comes out to 3,400 percent. (See my blog for details on this calculation.) But the Federal Reserve has ruled that overdraft fees are not considered finance charges that have to be disclosed, a spokesperson said.

Preying on the Most Vulnerable

Overdraft loan abuses fall mostly on the backs of middle- and lower-income consumers with little financial education, like Paddy Page, an Idaho mother of four. She receives no child support from the abusive husband she left six years ago, who's now in prison.

Page, who dropped out of high school but eventually earned her GED, works full time as a bill collector for Citibank, making $12 an hour. With no family nearby, she was on her own after her divorce.

"Once you get caught in the cycle, it's hard to get out of it," Page says, adding that most of her overdrafts were for groceries and medical bills for her kids. She racked up nearly $500 in overdraft fees last year at Washington Mutual Bank -- $243 of it over a two-day period in August, for nine overdrawn transactions.

Sleepless Nights, Tipped Scales

Like many consumers, Page didn't maintain her checkbook register, relying on her online account balance -- which didn't factor in outstanding paper checks. And because Page chose Washington Mutual's "free" checking account, she wasn't eligible to open a cheaper line of credit.

"I couldn't make it. There were times when I had no money and no groceries," she recalls. "I'd go to the grocery store and think, 'What else can I do?' I'd write a check, the bank would cover it, and on my next paycheck I'd be fighting to get back up to zero in my account. I couldn't sleep at night; I was about to lose my home."

Clearly, the consumer who spends more than he or she has is at fault. But the scales may be tipped against them: The Check Clearing for the 21st Century Act, approved in 2004, allows banks to clear checks they receive more quickly than in the past. But the act doesn't require financial institutions to credit deposits any faster.

Page, for instance, says she would sometimes make a deposit and get hit with an overdraft fee because the credit didn't clear as quickly as she expected.

Without Warning

Consumer advocates would like to see banks provide a warning to consumers if a transaction would overdraw their account. Similar technology already exists: When you use another bank's ATM, you sometimes receive a warning that you'll pay a $1 or $2 fee. You can choose whether to pay the fee or cancel the transaction.

A survey conducted by CRL earlier this year found that three-quarters of consumers wanted to be warned if they were on the verge of withdrawing more than they had in their account.

But the American Bankers Association (ABA) says it would be unfeasible to apply the technology this way; it would lengthen transaction times and raise the costs to merchants and consumers. "Consumers are in control of their finances and can avoid overdraft fees," said Nessa Feddis, ABA senior federal counsel, in a Congressional hearing earlier this month.

A Happy Ending

Happily, Page got back in control of her finances with the help of a fellow church member who's a financial executive.

They worked together to create a budget; get on time with her bills; learn to steer clear of high-fee payday loans and check-cashing stores; and pay off her credit cards.

Page's oldest two children are now in college. "I tell my kids all the time that education will set you free," she says. "You don't want to be bouncing checks and always scrounging money just to have groceries. It's ridiculous."

Help on the Horizon

Representatives Carolyn Maloney (D-N.Y.), Barney Frank (D-Mass.), and Julia Carson (D-Ind.) are sponsoring legislation (HR 946, or the Consumer Overdraft Protection Fair Practices Act) to protect consumers from abusive overdraft policies. The act contains four common-sense provisions to address some of the industry's sneakier tactics. It would:

• Require written consent from the consumer before enrollment in an overdraft loan program.

• Require financial institutions to warn the customer when an ATM withdrawal will trigger a fee -- and allow the customer to cancel the transaction at that time.

• Prohibit financial institutions from manipulating the order of check clearing or delaying the posting of deposits to increase customers' overdraft loan fees.

• Amend the Truth in Lending Act to clarify that overdraft fees are finance charges, so that annual interest rates are reported. This would allow consumers to compare overdraft loans with other credit options -- such as lines of credit, which typically offer annual interest rates of less than 20 percent.

Act Now

In her prepared remarks, the ABA's Feddis told the Congressional hearing that forcing financial institutions to report an annual percentage rate would confuse customers: "In these cases, the fee is fixed, the overdraft often small, and the term of repayment short. It is easy to see how triple digit APRs would result ... In the overdraft-fee context, consumers understand a dollar amount far better than an inflated and meaningless APR."

I think consumers are brighter than that: Given a chance to consider the APR on overdraft loans, they'd understand that their bank has been taking them to the cleaners.

Click here to email your support for the Consumer Overdraft Protection Fair Practices Act bill.