19th August 2020 | 6 minute read

Understanding overdrafts: a complete guide

In June 2019, the FCA announced there would be new rules about overdraft charging, designed to make overdrafts “simpler, fairer and easier to manage”, with the FCA saying it expected the cost of borrowing £100 on an unarranged overdraft to drop from £5 a day to 20 pence per day as unarranged overdrafts were regularly 10 times as high as fees for payday loans. It expected that 7 out of 10 overdraft customers would be better off under the new rules, where complex charging structures and fees would be replaced by a simple interest rate. The rules were introduced in phases, to come into full effect in April 2020 though temporary new rules were also introduced in April to help those affected financially by coronavirus and many banks delayed the changes.

What are the new overdraft fees?

In April 2020, finder.com reported that 2/3 of Brits don’t understand how much they are being charged for their overdraft. And with the added complexities of the pandemic, it’s essential overdraft customers understand exactly the cost of their borrowing.

Instead of charging high and often daily fees for authorised and unauthorised overdrafts, banks will charge a simple interest rate for overdraft borrowing.

Some banks have done this already and others are introducing their changes by the end of August, so you need to keep an eye out for exactly what is happening for you. Most banks’ rates are 34.9% or 39.9%, though Lloyds is charging up to 49.9% and the challenger banks are quite a lot lower, with Monzo at 19% and Starling at 15%, though to get those rates, you will need a good credit score.

To put that into context, the average credit card has an APR of 25.5% (Moneyfacts, June 2020), and even though interest on credit cards has been increasing to this all-time high, it’s still cheaper to borrow on a credit card than an overdraft from most banks, though you must make sure you know exactly what rates you are being charged on each type of borrowing and how and when they are applied.

Your bank should be making it very clear on their website what you will be charged, though it can be hard to work out your charges as your current account balance is likely to fluctuate throughout a month as money is paid in and then out again for outgoings. If you were permanently overdrawn by £100 (and not suffering coronavirus-related financial difficulties – see below), it would cost you between £35 and £40 per year for that with most banks, though some offer interest-free overdrafts at this level. For £1000, that would be £350 to £400 per year (so roughly £20-£35 per month).

What’s shocking is that for most people (remember 7 out of 10 ought to be better off), they should pay less than before but probably hadn’t really thought much about their overdraft costs until they changed. You are likely to be in the 3 out of 10 who pay more if you rely on your overdraft more to cover variations in your monthly income, such as those on zero hours contracts that are delivering shorter hours or the self-employed.

How do I get a better deal on overdrafts?

As ever, it comes down to knowing your APRs and shopping around. You could consider switching your borrowing from an overdraft to another form of credit, such as a loan, though smaller loans attract higher interest rates than bigger loans, they tend to be lower than an overdraft, with an average APR of around 10% (though this can near 30% for those with poorer credit scores). With a loan, you will need to make regular payments and approval for a loan will also depend upon your employment status as well as your credit score overall.

You could look at how you use your credit card, including a 0% card if you are eligible, that you could use for your day to day spending while you reduce your overdraft, though you must make sure you pay this off each month to avoid being charged interest, and for 0% cards, within the agreed window to avoid unnecessary interest.

Or you could switch bank, as long as your new bank is willing to offer you an overdraft at the rate you are hoping for. To get an overdraft approved, you typically need to pay your salary into that account and it will also depend upon your credit score, as with most borrowing.

What happens to my overdraft if my finances are affected by coronavirus?

In April, the FCA temporarily introduced specific measures to support customers with or about to have financial difficulties due to coronavirus, if they asked for it or it became clear support is needed. This included waiving interest on balances of up to or the first £500 for three months or more on arranged overdrafts, and making sure they would be no worse off on price when compare to the prices they were charged before the new rules came in.

In June, the FCA confirmed that customers financially affected by coronavirus can continue to ask for a reduced rate on any additional borrowing over £500 until October.

The FCA published the following in April 2020 for arranged overdrafts:

Up to and including £500: Interest free

Above £500: First £500 will be interest free. Standard pricing rate for borrowing above £500*

Arranged increases to limits below £500: Interest free

New overdrafts: First £500 will be interest free. Standard pricing rate for borrowing above £500*

*to be no worse than before the new rules were introduced.

If you are affected financially due to the impact of covid-19, speak to your bank to make sure you are getting the support you need. If you have already had support, you can ask them for further extensions and support and if you owe more than £500 they are obliged to help you find more affordable ways to repay.

You can also talk to a number of organisations to get help (see below) but, as we say in our 7-step guide to brighter borrowing, the number one thing to do is start now. Things will only ever get worse if you ignore them and the sooner you seek help, the better your situation will be.

Is the new overdraft system really fairer?

For some, it will cost them more, for most people, it should cost them less. And even though many banks’ overdrafts are priced similarly, the FCA isn’t opening an investigation at the moment but will keep things under review. One thing the new rules have done is shine a light on the cost of overdraft borrowing and ensure that it is transparent to all.

If you're concerned about your finances or are struggling with debt, the organisations on our Debt Helplines page can offer you additional support or advice. 

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*As referenced in the FCA's financial lives report and/or the credit card market report.