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- What is an overdraft? Uswitch explains
What is an overdraft?
An overdraft is when your bank allows you to spend from your current account more money than you have. The bank lets you borrow the money you don’t have. This is called being overdrawn. Think of it like a small flexible loan from the bank.
Since April 2020 banks have been banned from charging different rates of interest for different types of overdraft. Nor can they charge any fees. The regulator also set a maximum interest rate banks could charge and most banks charge close to the 40% maximum even for agreed overdrafts.
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What is an overdraft?
If you have an overdraft, this means that your bank is allowing you to borrow extra money through your current account.
So let's say you have no money in your current account, and you spend £50, this would make your current balance minus £50, and you have used your overdraft to make this payment.
Using your overdraft is like using money that the bank is loaning you, as it will be repayable. The type of current account you have with your bank will determine how much interest you will be charged over a period of time. Your bank should clearly display the cost of an overdraft.
Types of overdraft
There are two kinds of overdraft - authorised and unauthorised - and the difference between them is key:
Authorised
With an authorised overdraft, you have a set overdraft limit, which you pre-arrange with your bank. You are likely to have to pay interest on any money borrowed. The amount you will be offered as an overdraft will vary from person to person, and is usually determined by your personal finances.
Unauthorised
This is where you haven't agreed an overdraft facility with your bank in advance and have withdrawn more money than you have in your bank account, or you have taken out more than your authorised overdraft limit. Unauthorised overdrafts adversely affect your credit rating. The bank will demand you repay unauthorised overdrafts immediately.
When to use an overdraft
Overdrafts can be a good way to borrow small amounts of money, for a short period of time. But most overdrafts are not a very effective way of borrowing in the long-term, because they may come with a higher rate of interest than some loans and even some credit cards.
Even if your current account is always in credit, it can be a good idea to have an overdraft facility arranged with your bank, just in case.
Having an overdraft can act as a useful buffer to protect you from having payments declined and receiving negative credit reports if you ever accidentally overspend or find yourself needing a little extra money.
Accounts with 0% interest overdrafts are ideal for this kind of situation. These are also a good idea if you're trying to pay off your current overdraft. This will give you time to clear your current debt. However, it's important to remember they only last for a period of time, such as one year, after this time the interest rate will be close to 40%.
What to do if you rely on your overdraft
If you're frequently overdrawn, or often go overdrawn without authorisation then you should really check to see if you're getting the best deal on your current account. You could also look at switching your overdraft to a cheaper type of borrowing, such as a personal loan.
Tips for controlling your overdraft
There are a few things you can introduce to your daily routines, which can help you keep control of your spending, and ultimately manage your overdraft.
Check your account regularly - keeping track of your spending can help you stay on top of your finances, and pay attention to how close you are to your overdraft, or using an unarranged overdraft
Download your bank's app - having easy access to your finances will make it easier to see what's going on with your money. You can also set up notifications or alerts, to let you know when you're close to being overdrawn
Read all the letters/emails from your bank and respond if necessary - when dealing with debt, it can be easy to bury your head in the sand. It's important to not only know what's going on with your account, but to keep track of bank changes/charges
Consider using your savings - if you have access to savings, it might be worth using your savings instead of accessing an overdraft. This will save you having to pay overdraft fees, arranged or unarranged
Consider using savings to clear your overdraft if the costs per day are high
Consider using pre-paid debit cards for specific types of spending and stop when the money on the card runs out
Find a good overdraft rate
Compare current accounts from different providers and find a bank that offers an overdraft.
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