Everything you need to know about overdrafts

What is an overdraft?

An overdraft is offered by your bank or building society, so that you can continue to spend up to an agreed limit after your balance drops below £0.

With an overdraft, you can rest assured that if you spend more than you bargained for, perhaps because of an unexpected bill or outlay, you won’t be inconvenienced. 

Most current accounts come with an overdraft. Anyone with a standard current account can apply for one, although they aren’t available on children’s or basic current accounts. 

If you successfully apply for an overdraft, you’ll be advised of the maximum amount you can borrow. Ideally, this would be a sum that you could repay relatively quickly, as overdrafts are intended to be short-term loans. They’re not intended for long-term borrowing, and this is reflected in the high-interest charges that typically apply if you use them. 

How does an overdraft work?

There are two types of overdraft:

• Arranged 

• Unarranged

Here’s how they work:

Arranged overdrafts

If you’re granted an arranged overdraft, you can make cash withdrawals, purchases or payments after your balance has dropped to zero. The amount of money you can borrow is set by your provider. 

There’s no charge for setting up or having an overdraft to fall back on, but you can expect to pay interest if you use it. This interest is based on what’s known as the Annual Equivalent Rate (AER) and is often between 35% and 40%. 

An arranged overdraft still needs to be repaid at some point, and the account provider reserves the right to alter the rate of interest charged. 

Unarranged overdrafts

An unarranged overdraft comes into effect if you continue to spend after your balance drops below £0 and you haven’t agreed to an overdraft facility with your bank, or if you start to spend more than was agreed. Unarranged overdraft should be avoided as you’ll incur additional charges, and could even find your account and debit card blocked to prevent further spending.  

Should this happen, any payments, Direct Debits and standing orders would not be honoured by the bank. This could leave you facing the wrath of your landlord or mortgage lender or being sanctioned by your utility company or Council Tax collector.

Advantages and disadvantages of overdrafts

Around 15 million people in the UK have an overdraft, which shows how popular they are. But the fact that they are widely used, doesn’t mean they are always the best option. Here are the advantages and disadvantages of having and using an overdraft:

How do you get an overdraft?

Overdrafts are a key feature of most current accounts, and you’ll be given the option to apply for one when you open your account. 

As part of this process, you need to consent to the bank checking your credit file. The level of overdraft you get, if any, depends on what the provider finds in your credit report. 

Note: Overdrafts are not offered on children’s or basic bank accounts.

How much does an overdraft cost?

If you need an overdraft, you should focus on what interest charges will apply.  (There’s no point concentrating on the interest you can earn on a positive balance if you’re not going to spend much time in the black.)

To illustrate what difference the interest rate can make you your finances, let’s say you’ve been granted a £500 overdraft and quickly spend to this limit:

• If your interest rate is 35%, after a year you’d have paid £175 in interest, meaning you’re £675 overdrawn

• If your interest rate is 39.9%, after a year you’d have paid £199.50 in interest, meaning you’re £599,75 overdrawn

Some providers offer special rates for a limited period or if you cap your spending at a certain level. With this in mind:

• If your interest rate is 0% on any overdraft up to £250 and 39.9% for amounts exceeding that limit, after a year, you would have paid £175 in interest on a -£500 balance, meaning you would be £675 overdrawn.

How can you pay off an overdraft?

It’s far easier to get overdrawn than to clear the debt. Clawing your way out of overdraft requires certain sacrifices and determination, but it can be done. 

Here are some approaches to try:

• Use your savings: It might seem counter-intuitive to exhaust your savings, but if you’re earning less in interest than you’re being charged for your overdraft, it makes sense to clear the debt

• Switch bank accounts: Unless you already have the best current account for overdrafts, try searching the market for a better option. Contact the provider offering the best deal to see if it will offer you an overdraft that covers what you already owe. If so, go ahead and switch

• Get a 0% money transfer card: A money transfer credit card allows you to move cash straight into your current account, giving you time to pay off your debt. Take care to repay what you owe on your card before the 0% rate ends

• Take out a personal loan: If you can’t get an interest-free credit card, a personal loan may be your best bet. Most lenders will let you borrow upwards from £500, and loan terms start from one year, making it a good option if you feel you need some time to repay the loan

• Speak to your bank: Your lender may be willing to help, perhaps by freezing interest charges if you can prove you intend to repay what you have borrowed

In any case, at some point, you have to pay off what you owe, be it to your bank, credit card provider or loan company. This will involve reviewing your finances and revising your spending patterns. 

You need to know exactly what you have coming in each month, and what needs to go out – such as Council Tax, mortgage and utility bill payments. You should work out what you need to spend on essential groceries and transport. Cut down on all non-essentials, such as socialising, clothes shopping, treats and subscription services.