Put simply, an overdraft is a form of borrowing through your bank or building society current account. If you have an overdraft, you can spend or withdraw more money than you have in your bank account.
For example, if you have a balance of £15 and you spend £20, you’ll be £5 into your overdraft, with a balance of -£5 on your account. It is classed as a form of debt because it is not your money and you are spending more than you have deposited into the account, such as from your salary. Remember, it’s the bank’s money that you’re borrowing.
There are two types of overdrafts; an arranged overdraft and an unarranged overdraft. They’re exactly as they sound in that one is planned for, and the other is not.
An arranged overdraft, or authorised overdraft, is one that you have agreed with your bank or building society in advance of using it. An overdraft limit is set and you can spend or withdraw money up to that limit. The limit might be as little as £100 or less if you just want a little bit of added security. Or, in some cases, it might be as much as £5000 or more.
The limit you are allowed might depend on your credit score, account type and bank as well as additional information your bank holds about you (called your behavioural score) which is based on how you operate your accounts. This information enhances your credit score and helps the bank to make a more informed decision about you personally, rather than basing their decision solely on what’s in your credit report.
Arranged overdrafts can help you to manage your money if you have short-term or emergency expenses, or if a bill unexpectedly leaves your account. Even if you have an arranged overdraft, there will almost always be an overdraft charge.
An unarranged overdraft, or unauthorised overdraft, is one that you have not agreed to in advance. If you spend more money than you have in your account, or if you go over the agreed overdraft limit you already have in place, then this will be considered an unarranged or unauthorised overdraft. In some cases, banks don’t offer an unarranged overdraft and instead of allowing you to go into an unarranged overdraft, your payment will bounce. This means the attempted purchase or direct debit will be declined.
Both arranged and unarranged overdrafts have costs associated with them, however, you only pay them if you use the overdraft. Previously, arranged overdrafts typically had lower associated fees than unarranged overdrafts but, as of 2020, the new regulation has meant that providers are no longer allowed to charge higher fees for unplanned overdraft use.
Providers usually charge interest for the use of overdrafts, at a single annual interest rate (APR). They can range up to 40%, so make sure you shop around when considering where to set up an overdraft to avoid paying more than you need to. This may mean switching your current account, as providers usually need to see you are getting paid into the account that has an overdraft.
Alongside the interest (which varies based on your account and the provider), overdrafts also bring with them potential fees, such as fees for spending over the arranged limit. Similarly, if you have a payment bounce due to not operating within your overdraft limits and arrangements, you could be charged fees for those bounced payments as well.
When agreeing to, or starting to use an overdraft, make sure you fully understand the possible fees and associated interest. Your account provider should make this information easily available to you, either on their website or in your account documentation.
Overdraft charges can be high, so depending upon how much you use, and how often you use it, there could be cheaper ways to borrow.
There are different ways people choose to use overdrafts and, for some, they can be really helpful. Ideally, they should be used as a short-term solution, for emergencies rather than for spending beyond your means.
That’s because overdrafts are typically more expensive than other forms of lending, though not always. What you get charged depends on the number of days you use it, and the balance of the debt each month. This means that if you are in credit for 18 days of the month and debt for 12 days, the interest charge is applied over the 12 days when the account was in its overdraft. Keeping out of the overdraft balance for as many days as possible is key to reducing the overdraft interest charges.
If you had the same debt on a credit card and didn’t pay it off, it would attract interest for the whole month at the rate of the credit card, so it’s important to think about how you are using your debt and how much each facility costs. Very short term use of an overdraft may be cheaper than a credit card. Longer-term use of an overdraft might cost more, depending on your terms.
Whatever form of borrowing you choose to use, the best thing you can do to manage your borrowing well is ensure that you know the terms and conditions of use, and make a plan for the amount you’ll use and how you’ll pay it back.
Having an arranged overdraft, rather than relying on an unarranged one, will help to reduce the likelihood of facing high fees for bounced or returned payments.
However, it’s common for people to underestimate how much they use their overdraft so if you intend to use one, make sure you know the potential fees and interest rate upfront, and stick to the agreed overdraft limit to avoid being caught out. If you don’t, the overdraft could cost you much more than you realise.
Even the best laid plans can sometimes go wrong, so if you do find yourself further into your overdraft than planned, be sure to treat it as you would any other debt: work out what you owe and make a plan for how you intend to pay it off.
Below are steps you can take to start the process:
Get to know your spending, by creating a budget. Make a note of your income and your expenses, so you have everything written in one place.
Try to understand whether there are regular times at which you always use your overdraft.
Complete a money ‘health check’ to see if you can make any savings that will reduce your outgoings. Perhaps you could switch to a better deal for your internet, or mobile phone.
Move bill dates. You could ask companies you pay to move your direct debits to align better with your payday. Aiming for bills to come out about 5 days before your payday will boost the balance in your account for longer, meaning you will be in the red for a shorter period of time. This will reduce the amount of interest charged, meaning you’ll have more money in your account than otherwise. You need to be disciplined though, and remember not to spend the cash before the bills are due for payment or things will only get worse.
Ask for a lower interest rate. Check with your bank or building society if you are eligible for a lower rate of interest. If they agree, it’s still important to work to reduce your overdraft debt, as the new offer may be limited or even withdrawn in the future.
Adjust your overdraft limit as you go along. Once you have started to reduce the size of your overdraft, it may be tempting to dip back into your overdraft to its limit. Instructing your bank to reduce your overdraft limit to a lower amount could help you to avoid this in future.
Think about using your savings. The interest gained on regular savings accounts is relatively small at the moment, so it doesn’t make sense to have a large savings account whilst having an overdraft which is high in interest charges. A £2000 balance in a savings account may only give a return of around £50 per year, while an overdraft fee could be ten times that much at around £500 per year (depending on the interest charged). It always feels good to have a ‘nest egg’ but this could be a false economy.
Balance transfer. Consider a balance transfer to either a lower rate credit card or loan. Make sure you check the date that the lower interest rate expires and make sure you can pay off the balance in full before that date.
Yes, you can but you will need to develop this discipline yourself, as there are no repayment plans with an overdraft. The overdraft has been allocated to your account and unless the bank or building society cancels the overdraft facility, you can remain within the overdraft limit throughout the month.
How do I know how much my overdraft is costing me?
It can be tricky to work out how much your overdraft will cost, as it depends on your usage and the specific account terms and conditions. However, your bank should always inform you if the terms of your account are changing, including whether any fees are to change also. If you’re unsure, you can contact them and ask them to provide clarification.
Why do I need to set and stick to a budget?
Understanding your spending habits will allow you to better see where you can make changes to help reduce what you owe as soon as possible. Overdraft debt can be expensive due to the interest rates charged so, once it's paid off in full, the money you were spending on interest will then be additional income for you to use as you choose.
How long will it take to pay off my overdraft?
This depends completely on how much of your overdraft you’re using, the interest rate on it and any additional fees that you might have incurred. Once you have a good grasp of your budget and current spending, use the steps above as a basis for taking control of your overdraft and begin paying it down as soon as you’re able.
If you’re struggling to pay off your overdraft then you should ask for support as soon as possible. You can either contact your bank or building society directly and discuss a plan to pay it off, or you can seek professional independent advice from one of the many charities that offer their services free of charge. You can find a list of these on our Debt Helplines page.
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