An overdraft is a form of credit your bank may offer if your current account balances drops below zero. When you have spent more than is available in your bank account, this is called being overdrawn. An overdraft is a form of a loan of money that you will owe your bank.
For example, if your bank balance is zero and you withdraw £50, you would then have a negative balance of £50 and you will then be overdrawn.
These can be the cheapest way to borrow small amounts of money for a short period of time such as an emergency bill or have run out of money before payday. But be aware, make sure you understand the fee structure of your overdraft.
How do they work
An overdraft maybe offered as part of your bank account package or you may need to apple for one separately from your bank. The amount offered will largely depend on two things:
- How much the bank is prepared to offer
- Your financial health. Some banks may make an assessment on your income and credit score before determining its maximum limit
If you exceed your limit, some banks may let you continue to go over. There might be a limit applied that will stop you spending, so it is worth asking your bank if you have one.
What are the different types
There are two types of overdrafts:
- Authorised overdraft. This is prearranged with the bank that will give you a set limit. You’re likely to have to pay interest or a fee int return for the facility.
- Unarranged overdraft. These are not pre-agreed maybe due to having not arranged an overdraft at all or have exceeded your arranged limit. Banks can no longer charge more for unarranged overdrafts than for arranged ones, but this could still negatively impact your credit score.
How much do they cost
Overdraft fees consist of an interest charge of an equivalent annual rate (EAR) range from 0% up to 39%.
Banks used to charge several fees and interest charges for overdrafts on authorised overdrafts. These very same fees and charges used to be charged at a higher rate for unauthorised overdrafts.
The FCA announced changes to how overdrafts are priced and offered to the public in June 2019.
- Unarranged overdrafts can no longer be priced higher than arranged overdrafts
- A ban on fixed daily or monthly overdraft fees
- A ban on fees to have an overdraft available
- The use of a simple interest rate (EAR) for overdrafts
- Mandatory use of annual percentage rates (APRs) for overdraft pricing on advertising
- More action to identify those who show signs of financial distress and to implement strategies to reduce repeat overdraft usage.
How they affect your credit score
Using any financial product that lets you borrow money shows up on your credit record, including a bank account with an overdraft facility.
If you apply for a loan, mortgage, credit card or any other form of borrowing, the company will check your credit record. If you owe too much on your overdraft or frequently go over its limit, this could make lenders less likely to accept you.
Do you need an overdraft
Overdrafts should be used as a short-term option. They can be a useful backup in emergencies but when used repeatedly may be a sign of a larger financial problem and could prove more costly than an alternative source of credit. It’s always better to have an arranged overdraft than to go overdrawn without agreement from your bank.
What are the alternatives
If you occasionally drop into your overdraft as a result of occasional shopping habits, it is worth considering using a credit card instead. Many will offer an interest-free grace period plus the added benefit of purchase protection. However, ensure you are able to clear the payments in full by the due date.
If a credit card is not the solution, a personal loan may prove to be more suitable to your situation and can be paid back in the longer-term.
