How does an overdraft work?
An overdraft is a form of debt. Your overdraft lets you spend more than you have in your current account
What is an overdraft?
Most current accounts come with an overdraft. Overdrafts give you the option to spend more money than you have in your account – this is called going ‘overdrawn.’ You’ll go into your overdraft if you make a purchase or withdraw cash for more than is available in your account – so you’ll end up ‘below zero’ or in debit on the account.
An overdraft is a form of debt that you’ll need to repay and there may or may not, depending on the type of current account you have, be interest added on top. Some student current accounts come with an interest-free overdraft for several years, for example.
While overdrafts can be a convenient way to borrow money in the short-term, they can charge high-interest rates so make sure you check exactly what you’ll owe before you start using it.
How do overdrafts work?
Once you spend more money than you have in your current account – you’ll go overdrawn – usually shown as a negative balance. There are two types of overdraft: authorised and unauthorised.
It’s important that you remember an overdraft is a type of a loan and form of borrowing. So, you should be confident you can repay the money you’ve borrowed – and any interest it may accrue. If you don’t do this, you run the risk of damaging your credit score or building up significant debts.
For student current accounts your overdraft is likely to be interest-free and you’ll be expected to pay it back within two to three years after graduating. Banks can only charge you an annual interest rate for both unarranged and arranged overdrafts, meaning you won't pay any additional fees or charges - but entering an unarranged overdraft can negatively impact your credit score, so if you're looking to borrow, apply for an arranged overdraft.
How can I pay back my overdraft?
Unlike a loan or credit card, overdrafts don’t come with a repayment plan so paying off the debt is entirely down to you. To pay off your overdraft, you’ll need to get your current account balance back above zero. Here are some ways you could pay off your overdraft balance:
Use your savings: If you have money set aside in a savings account it could make better sense financially to use some of it to clear your overdraft particularly if you’re paying high interest on your borrowing
Transfer the balance: If your interest rate is high, you could use a money-transfer credit card to clear the debt built up in your overdraft. You may get a 0% interest period for 18 months in some instances
Switch providers: If you switch to a new bank, you could be offered an interest-free period on your overdraft for a set amount of time. This could help you avoid interest building up while you’re paying off your overdraft balance
Take out a loan: A low-rate personal loan could make paying off your overdraft more affordable, especially if the loan comes with a low-interest rate
What types of overdraft are there?
Most current account overdraft facilities are divided into two groups, authorised and unauthorised:
An authorised (or arranged) overdraft is arranged with your bank, and usually comes with an agreed borrowing limit – this can be anywhere from £250 to £3,000. While most banks will set up an authorised overdraft for free, in some cases – and often with business bank accounts - there may be a small arrangement fee. Your overdraft limit will depend on your bank. Some banks have a set amount for overdrafts e.g. £500. Other banks may determine your overdraft limit based on your credit score and financial record.
An unauthorised (or unarranged) overdraft is borrowing you haven’t agreed with your bank. You’ll go into an unauthorised overdraft if you go over your authorised overdraft limit or if you overspend when you don’t have an agreed overdraft with the bank. Sometimes, when you enter an unauthorised overdraft,you will have until the end of the day to get your account back in credit. If you don’t, you will face a daily fee.
While lenders can’t charge you a higher rate of interest for going into an unarranged overdraft, there could still be negative effects associated with doing so, such as:
Damage to your credit rating which could hurt your chances of obtaining credit in the future
Bounced payments like direct debits or standing orders. This is known as returned items- as you don’t have the funds available in your account to cover the payment. Some banks may charge a fee for a returned item. If the payments were for debt repayment or utility bills this could also affect your credit score
You’ll be paying interest on more borrowing, so your debt costs will be higher
Some banks will ask that you repay any unauthorised borrowing within a short time frame, such as within the month
Am I eligible for an overdraft?
To be eligible for an overdraft, you’ll usually need to meet the following criteria:
Personal details: You must be aged 18 or over and a UK resident
No county court judgements: Most banks will ask that you have no county court judgements against you for the last few years (individual banks will specify how many years as policies will vary)
No bankruptcy: You’re not likely to be accepted for an overdraft if you’ve been declared bankrupt in recent years (terms and conditions will vary between current account providers)
No missed credit payments: Most banks will ask that you haven’t fallen behind with any credit payments or you’ve missed credit payments in the last few months
If you’ve struggled with debts in the past and have a poor credit score, you may not be accepted for an overdraft. This is because your bank will have less evidence that you’re a reliable borrower. Look at ways to improve your credit score to boost your chances of securing an overdraft. Our credit monitor tool is a free, easy way to monitor your credit score – with helpful tips on how to improve it.
How much does an overdraft cost?
How much an overdraft will cost you will depend on the arrangement you have with your bank. You’ll usually fall into one of the following categories:
Interest-free: Interest-free overdrafts work like an interest-free loan, and you won’t face any charges for this borrowing. Some accounts offer an interest-free buffer on an agreed overdraft, usually up to £250, before implementing interest charges. Others, such as student or graduate accounts, might offer an interest-free agreed overdraft of up to £2,000
Agreed interest: If you’ve exhausted your bank balance and interest-free buffer (if you have one), your bank is likely to start charging you for using your overdraft at a set interest rate. In most cases, it will be interest charged on the amount you’ve borrowed, though some may charge interest as a percentage of the full overdraft amount
Advantages and disadvantages of overdrafts
Undecided about whether to use an overdraft?Here are some potential advantages and disadvantages to consider:
Advantages of overdrafts
Flexibility: Unlike a loan, where you’ll borrow a set amount and repay over a fixed period, an overdraft gives you a way to borrow the exact amount you need immediately and repay when it suits you
No early repayment charge: You shouldn’t be charged a fee for paying back any amount of your overdraft at any time
Quick to apply for: There’ll be less paperwork than applying for a loan – often you’ll get an overdraft automatically with your current account application
Disadvantages of overdrafts
Less money to borrow: The amount of money you can access through your overdraft tends to be lower than with a personal loan
Interest charges: The interest charged on overdrafts can be high, which can make it an expensive way to borrow long term
Over-spending: Spending is coming out of your current account so if you don't keep an eye on your debit card use you could end up with a large overdraft that's hard to pay off (most banks will send text alerts if you're close to your overdraft limit)
What are the alternatives to overdrafts?
If you would prefer not to use your overdraft, there are other ways to borrow:
Credit cards: If you’re looking for flexible borrowing then credit cards could be for you. You won’t be able to borrow as much as you can with a loan, but if you’re looking to make payments that depend on how much you spend – then a credit card is an option
Loans: Loans are more of a long-term borrowing alternative to using your overdraft. When you take out a loan, you borrow from a lender – usually a bank or another type of financial organisation. Once you’ve been accepted for a loan, you usually make monthly payments until the debt is cleared. There are different types of loans, such as; secured, personal and guarantor. There are also bad credit loans designed for those with a low credit rating
Does an overdraft affect my credit score?
Your overdraft, and more importantly the proportion of it you use each month, contribute to your overall indebtedness which in turn affects your credit rating. Lenders look at your outstanding debts for example when making lending decisions.
Using an overdraft can affect your credit score – especially if you go beyond your agreed overdraft limit. This is because lenders are likely to see you as managing credit poorly if you struggle to clear your overdraft balance and regularly exceed your overdraft limit. If you were to enter an unarranged overdraft, this is likely to negatively impact your credit rating as it will indicate to lenders that you’re struggling to manage your finances.
If you have an arranged overdraft but don’t use it (or use it occasionally but clear it quickly) this shouldn’t affect your credit score. In fact, if you use your overdraft sensibly (and don’t exceed your overdraft limit) and regularly pay it off, it could actually improve your credit rating over time.
How can I avoid going into overdraft?
Although overdrafts are a way to help you borrow, they come with high-interest fees. So if you can, you should especially avoid going into your unarranged overdraft. Here are a few tips you can use to stop you from slipping into the red.
Regularly look at your bank statements: Sometimes, you need to sit down and have a good look at what you’re spending your money on. Whenever you can, have a deep dive through your finances and think about what you could cut back on. As more of us use contactless payments, it can sometimes feel like we’re not spending real money. So,it’s important to regularly check your bank balances so you can keep track of your spending.
Set up text alerts: If you’ve registered your phone number with your bank you might get text alerts when you’ve entered your arranged and unarranged overdraft. You may even be able to set up a text alert with your bank when your balance reaches a certain amount. Having text alerts when you make purchases can also help you stay aware of what you’re spending and if you’ve been incorrectly charged.
Speak to your bank: If you’re aware you might enter into your unarranged overdraft then speak to your bank and let them know. Your bank could arrange an overdraft for you without you needing to extend your current one. Some banks will do this once as a gesture of goodwill, but this shouldn’t be thought of as a permanent solution.
Start to save: If you’re able to, you should think about setting up a savings account. Putting away sums of money regularly can start to add up and could in time build you a nice savings pot. The money in your savings can help to clear your unarranged overdraft or prevent going into it all together. For savings, you can access whenever you please, consider an easy-access savings account.
Other useful guides
Here at MoneySuperMarket, we have a range of guides to get you clued up on current accounts:
How to switch current accounts
How to choose the best current account for you
Compare current accounts with MoneySuperMarket
If you're looking for a current account with an overdraft you can compare leading accounts with MoneySuperMarket. We can show you a broad range of accounts from across the market and searching won’t affect your credit score.