Overdrafts explained: A complete guide
What happens when you spend more money than you have available in your bank account? Our guide explains what being overdrawn means and how if might affect you
What is an overdraft?
An overdraft is a way of borrowing from your bank to spend more than you have in your current account. They can be useful to manage your finances, but could also prove expensive if used poorly.
You’ll go into your overdraft if you make a purchase or withdraw cash that takes you ‘below zero’ or in debit on the account. Depending on the type of current account you have, you may have to pay interest on the overdraft.
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?
Overdrafts are fairly simple to understand. The key points are as follows:
You go into your overdraft when you spend more money than you have in your current account. This is called being overdrawn.
There are two types of overdraft: authorised and unauthorised. An authorised overdraft is where the bank has provided a specific facility for you to go overdrawn. This does not always mean it’s interest-free
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 interest rates on overdrafts from banks and building societies can be high, ranging from 19% to 40% or more
Entering an unarranged overdraft can negatively impact your credit score. So if you're looking to borrow, apply for an arranged overdraft
If you don’t repay what you owe on time, 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 of graduating
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 over your interest-free limit.
Can I get an interest-free overdraft?
Whether you can get an interest-free overdraft will depend on your bank or building society and their view of you as a customer.
For example, students are often given interest-free overdrafts as an incentive to sign up as new customers when they are young.
Customers with a better credit score are more likely to be offered an interest-free overdraft too because they are seen as a lower risk of not repaying what they owe.
It’s worth noting that because all interest-free overdrafts are given at the account provider’s discretion, they can also remove them at short notice.
The bank should always give you warning and a chance to repay what you owe, but it’s another reason why overdrafts shouldn’t be seen as a way of long term borrowing.
What are the different types of overdraft?
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’ because 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
What are the advantages of overdrafts?
An overdraft has several potential advantages, including:
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
What are the disadvantages of overdrafts?
There are also some downsides to being overdrawn, including:
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)
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
Does an overdraft affect my credit score?
Using your overdraft could affect your credit rating because lenders look at any outstanding debts when making lending decisions.
Your credit score is more likely to be negatively affected if you use an unauthorised overdraft or go beyond your agreed overdraft limit because lenders are likely to see you as managing credit poorly.
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.
How can I avoid going into my overdraft?
Overdrafts often charge high interest, so are usually best avoided. Here are a few tips you can use to stop you from slipping into the red.
Regularly check bank statements: Take a deep dive through your finances and think about what you could cut back on before you go overdrawn
Set up text alerts: Arrange a text alert with your bank when your balance drops below a certain amount. This can warn you you’re approaching your overdraft
Speak to your bank: If you’re aware you could enter into your unauthorised overdraft let your bank know. They might be able to extend your existing limit
Start to save: Consider setting up and regularly topping up an easy access savings account which could be used to clear an overdraft in an emergency situation
Can I switch banks if I am overdrawn?
You may be able to switch banks if you’re currently overdrawn, but your existing overdraft will need to be agreed with your proposed new bank or building society before the switch. If your new bank won’t offer you an overdraft up to the amount you are already overdrawn, you’ll have to repay what you owe before switching.
Is an overdraft right for me?
An overdraft should only be seen as a way of managing your finances in the short term.
If this is the case and you need more money than you currently have in your current account, then it might be right for you.
It’s easier and quicker to set up an overdraft than a loan or credit card and by definition you’ll only borrow the exact amount you need.
However, always make sure it is authorised by your bank first and understand the interest charges you face, as they can be more expensive than other ways of borrowing.
Other useful guides
Here at MoneySuperMarket, we have a range of guides to get you clued up on current accounts:
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