9 min read

How do overdrafts work?

Andre Spiteri
12 April 2017

We look at what you need to know about overdrafts - how to set one up and the things you need to watch out for.

While, in an ideal world, you’d always have enough cash to last you until your next pay cheque, emergencies can and do come up. Sometimes it’s an unexpectedly high utility bill. Or maybe it’s an unplanned expense. Either way, unless you have a rainy day fund that you can dip into when this happens, an overdraft might be your only option.

As convenient as they are, overdrafts should be approached with caution. They can be an expensive way to borrow – and a worrying 10% of Brits never manage to pay theirs off in full*.

What is an overdraft?

An overdraft allows you to borrow money through your bank account - usually your current account.

There are two types of overdraft: authorised and unplanned. Authorised and unplanned overdrafts work slightly differently from each other. They also carry different interest rates and fees.

You can see your overdrafts on your credit report. Check yours for free with ClearScore.

Authorised overdrafts

In an authorised overdraft, you agree with your bank in advance that you can borrow up to a certain amount from your account. This is known as your overdraft limit.

Your overdraft limit will depend on your personal circumstances, and will be reviewed periodically. When you first apply, your bank will look at the regular monthly incomings and outgoings in your account, your employment situation and other financial commitments. They may also look at your credit report and score.

Authorised overdrafts usually attract interest, fees or both. Some current accounts also come with an automatic free overdraft, but this is typically very limited compared to what you can get from an authorised overdraft.

Interest-free overdrafts
Some banks advertise “interest-free overdrafts”. However, the interest-free offer usually only applies to a small part of your overall limit. Anything over this amount will attract interest at the normal rate.

Unplanned overdrafts

Unplanned overdrafts - also known as unauthorised overdrafts - are overdrafts that happen in one of two ways:

  • when you go over the pre-agreed limit on your authorised overdraft; or

  • when you don’t have an authorised overdraft in place and take out more money than you have in your bank account.

An unplanned overdraft tends to be much more expensive than an authorised overdraft, which means it’s best avoided. The applicable charges vary from bank to bank. However, the interest rate and fees are typically higher than those charged on an authorised overdraft.

More importantly, you’ll usually be charged a fee on every transaction you attempt to make while overdrawn. The transaction fee normally applies regardless of whether the transaction actually goes through or not.

Grace periods on unplanned overdraft
Many banks offer grace periods that allow you to rectify the situation if you inadvertently go overdrawn. Typically, you’ll be able to avoid the charges if you top up your bank account within a set time-frame. If you don’t, however, interest and fees will usually start to apply from the moment your account goes overdrawn.

Using an overdraft: the pros and cons

Overdrafts have two main advantages: they’re easy to arrange and they’re very flexible.

Arranging an overdraft

Getting an overdraft is usually simply a question of filling in an online application or calling up your bank. You can usually get an answer within minutes.

Depending on your standing with your bank (meaning how trustworthy they perceive you to be), you may also be able to extend your limit, even temporarily, simply by calling them up.

Flexibility

Flexibility is probably the biggest advantage of an overdraft. Provided you don’t exceed your limit, you’re free to take out as much or as little of your overdraft as you like. And you’ll only pay interest and fees on the actual amount you borrow.

Overdrafts also have flexible repayment terms. You can pay off your overdraft over a number of months (or even sometimes years). Or, alternatively, you can pay it all off in one lump sum without incurring an early repayment fee.

Overdrafts and your credit score
An authorised overdraft is a form of credit. Using it responsibly - that is borrowing sparingly and repaying it in full - will add positive information to your credit history, which could help to improve your credit score. If, on the other hand, you have long-standing overdraft debts or regularly go into an unplanned overdraft, this can have a harmful effect on your credit score.

The disadvantages of using an overdraft

Unfortunately, flexibility comes at a cost. Overdrafts have some significant downsides. And these disadvantages mean that overdrafts are normally only suitable for emergencies and other short-term borrowing needs, not as a long term solution.

  • Overdrafts are expensive, even when authorised

Interest, fees and charges are steepest on unplanned overdrafts. However, authorised overdrafts aren’t exactly cheap, either.

The interest rate on most authorised overdrafts currently hovers at around 16% to 17%. While this is slightly lower than the rate on many credit cards, it’s significantly higher than the interest rates on many personal loans.

Many banks also charge overdraft fees in addition to interest, even on authorised overdrafts. These fees are typically in the region of £3 to £6 and they may apply on a monthly basis or even daily. When coupled with the interest on the amount you borrow, they’re a double-whammy. Both interest and fees are variable, which means they can change at any time.

Steep overdraft fees are the subject of an ongoing regulatory discussion. Its a controversial issue and is yet to be resolved.

Helpful hint
Short-term borrowing on a 0% interest credit card will usually work out much cheaper than using your overdraft and it will still give you a reasonable level of flexibility.

  • Overdrafts are repayable on demand

Your bank can demand repayment of any amount outstanding on your overdraft in full at any time. If you’re unable to meet this demand, your bank has the right to take the money directly from any bank account you hold with them.

  • Your overdraft limit can change at any time

Your overdraft limit isn’t guaranteed. Your bank will typically review it regularly. Your limit can be revised upwards or downwards, which could leave you with access to less credit than you thought you had.

With that being said, you have a right to file a complaint with the bank or with the Financial Services Ombudsman if your overdraft limit is revised downwards without notice and you incur unplanned overdraft charges as a result.

  • It can be hard to clear your overdraft debt

Flexible repayment terms, interest and daily or monthly fees can be a deadly combination if you’re not careful. Interest and fees usually start accruing from Day 1, which means your debt can quickly become unmanageable unless you commit to making regular repayments.

Helpful hint
If you’re struggling to repay your overdraft you may want to consider cheaper ways to borrow such as a personal loan. While you’ll need to commit to regular monthly repayments, you may pay less interest and no daily or monthly charges. The more structured repayment schedule may also help you become more accountable and make your debt more manageable.

*According to a survey carried out by Moneysupermarket.com

In a nutshell:
  • Overdrafts allow you to borrow money through your current account.

  • Overdrafts can be authorised or unplanned. Authorised overdrafts usually have lower fees and charges than unplanned overdrafts.

  • On the downside, overdrafts can be an expensive way to borrow and your limit isn’t guaranteed, which means they’re best-suited for emergencies, not as a long-term borrowing solution.

  • Overdrafts, on the plus side, are flexible and relatively easy to arrange.

by Andre Spiteri

Andre is a former lawyer turned financial writer. Trained in London but originally from Malta, he used to work for the Maltese Financial Services Authority - which means he really knows his stuff about finance. Andre has written this article especially for ClearScore.

ClearScore exists to make your finances simple.
We offer a free service where you can handle everything to do with credit in one place. In your ClearScore account, you can see your credit score and the full details of your credit report. Your credit cards, mortgages, mobile phone contracts, loans, overdrafts and utilities all on the record. Our goal is to make ClearScore as simple, calm and straightforward as possible. Money is stressful enough.