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.
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.
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.
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 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.
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.
- 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.
*According to a survey carried out by Moneysupermarket.com