Overdraft coming to prepaid cards, with heavy restrictions

More consumers who use prepaid debit cards will be able to spend more than their balance, starting next October. But if that feature sounds very much like overdraft protection on a traditional checking account, well, there are some key differences.

The new rules, finalized by the Consumer Financial Protection Bureau in October, will make prepaid debit cards even more like traditional checking accounts, but also will require customers who want overdraft protection to apply for it like a credit card.

Customers have generally not wanted the ability to overdraft a prepaid debit card, and only a small minority of prepaid card issuers offer overdraft as a feature. Consumer advocates say the CFPB's rules could make overdraft more common among prepaid debit card companies, but generally customers are against it.

Once a product whose only purpose was to function as a gift card, prepaid debit cards have become popular over the last 15 years for many Americans, who use them as an alternative to a traditional bank account. Roughly $65 billion was loaded onto prepaid cards in 2012, the most recent year for which data are available. That's more than double the amount loaded in 2009, only three years before. The amount loaded is expected to double again by 2018, according to the CFPB.

And as they have grown in popularity, the cards have developed many features that mimic a traditional checking account. But one feature of checking accounts that the vast majority of prepaid debit card features didn't have was overdraft. Mainly because prepaid debit card customers didn't want it.

A 2015 study by the Pew Charitable Trusts showed that 72 percent of prepaid debit card users listed the ability to "avoid overdraft fees" as a primary reason why they liked using the cards. The only prepaid company of any significant size that offers overdraft protection is NetSpend.

Once the rules go into effect in October 2017, prepaid overdraft protection will look more like a credit card compared to overdrafts in checking accounts.

For example, banks can offer overdraft from the opening of a checking account, while prepaid debit card companies have to wait at least 30 days. Customers will also have to formally apply for the feature instead of it being a default feature found on many checking accounts.

Most importantly, overdraft protection with prepaid debit cards will operate more like a separate line of credit, under the CFPB's finalized rules. A customer who overdrafts their account will receive a statement with monthly payments, and the overdraft feature will be considered separate from the main account.

"The type of overdraft would be similar to overdraft lines of credit. When you overdraw the account, the bank will dip into a separate line of credit. You just pay an interest charge on those funds you access. It just allows for prepaid to have a credit card function," said Thaddeus King, head of the consumer banking project at the Pew Charitable Trusts.

For example, if a customer has a $50 balance on his or her overdraft protection and makes a $200 deposit, the $200 deposit could not be used automatically to pay the $50 balance and the customer would have to make arrangements to pay off the $50 balance separately. In contrast with a traditional bank account, a $200 deposit would first go to bring the account to a zero balance before making the funds available, making that $200 deposit really $150 after paying off the $50 overdraft.

But that overdraft protection will come at a price, an interest rate of as much as 25 percent.