If you need money for an emergency, or to cover unexpected costs, an overdraft can be a convenient way to borrow over the short term.
However, it’s important to remember that when you’re dipping into your overdraft, you’re going into debt. An overdraft is a loan, and like any form of debt, you need to know how you’re going to repay it and ensure you’re aware of any interest charges that may be applied.
Bear in mind that while an overdraft can be a flexible way to borrow, there might be other, cheaper forms of borrowing available to you, depending on your bank’s charges.
Here, we look at what you need to know about overdrafts, including what they are, how they work and how to manage them if you find you’re sinking into the red.
What is an overdraft?
An overdraft is a way to borrow money through your current account by withdrawing money or making payments that takes you beyond your available bank balance. So, if you dip below £0, you’ve gone into your overdraft. This is known as being “overdrawn”.
Bank accounts generally come with some sort of overdraft facility, along with information on the specific charges involved. However, if your account doesn’t offer an overdraft, you can usually request one from your bank.
What are the different types of overdraft?
There are two types of overdraft – an arranged overdraft and an unarranged overdraft. These are also known as “authorised” and “unauthorised” overdrafts. However, rule changes introduced in April 2020 by the UK financial regulator, the Financial Conduct Authority (FCA) brought charges for both types into line (see below).
Generally, however, an arranged overdraft is one that you have agreed in advance with your bank, and typically comes with a ‘buffer’ amount that’s interest free. This is the amount you can go into your overdraft without paying interest. Sometimes a current account will come with an overdraft already in place, and you should have received details of this when you opened the account. Typically, you may receive an overdraft facility of between £250 and £3,000, depending on what you agree with your bank or the overdraft facility that’s already in place.
If you exceed this limit on an arranged overdraft, then you move into what’s known as an unarranged overdraft.
The main reason you’ll want to stay within an arranged overdraft is your credit score. If you manage your arranged overdraft well and pay it back in good time then this will be treated like paying back any other type of loan, and help to build your credit score. However, if you dip into an unarranged overdraft, then this will likely hurt your credit, even if you pay it back in good time.
How much interest is charged on an overdraft?
Like any type of loan, you will likely be charged interest for dipping into your overdraft, and if not used carefully, they can be one of the most expensive ways to borrow. However, your bank should state clearly what interest you will be charged on your overdraft, and have a calculator in place for working this out if you’re unsure.
Major changes affecting the way that interest rates are charged on overdrafts were introduced in April 2020. Banks used to charge higher interest rates on unarranged overdrafts, amounting to as much as £10 a day, but since then they have not been allowed to do this. Banks are also not allowed to charge daily or monthly overdraft fees. There must be a single interest rate charged on any overdraft, which makes it easier to compare the charges on different accounts. However, beware that interest rates vary widely on overdrafts, and may range from 19% to as much as 40%, so it’s vital to understand how much you’re being charged.
However, arranged overdrafts typically come with an interest-free buffer that allows you to go slightly into your overdraft without building up any interest. This is usually somewhere between £25 and £250. Once you exceed this buffer, you’ll start being charged interest at the normal rate.
Interest rates from banks tend to be between 19% and 40% annually, though interest will be automatically added onto your balance in small daily increments, rather than once a year. Make sure you know what your bank’s interest rate on overdrafts is, and whether they have an interest-free buffer, before arranging an overdraft or dipping into one. Again, most banks will have an online calculator to help you figure out how much an overdraft will cost you.
Alternatively, some banks will simply charge you a flat, regular fee for using your overdraft rather than calculating interest. For example, your bank might charge you £1 per every day that you are overdrawn.
You should make sure you know exactly how your bank charges you for your overdraft – whether through interest or flat fees – before making use of it.
Bear in mind that student and graduate accounts usually come with an interest-free overdrafts, but the amounts on offer vary.
How do I pay back an overdraft?
Paying back an overdraft is simple, provided you have funds available to do this, as all you need to do is transfer money into your current account to clear the amount you owe. Once your balance is back up over £0 then you’ll have paid your overdraft off. Even if you can’t pay it back all at once, making transfers whenever you can to bump it back up will reduce your interest charges, as these are calculated daily based on your balance. A smaller outstanding debt will therefore mean smaller interest charges, and less to pay off overall.
If you have a tendency to overspend or you’re on a strict budget, you can ask to reduce your overdraft limit up to 14 days after it’s agreed, or you can cancel your overdraft facility at any time. But you’ll have to repay anything you owed, plus interest if applied.
What happens if I don’t pay back my overdraft?
If you leave your overdraft unpaid for too long then the interest will build up steadily, and you’ll end up having to pay back much more than you borrowed. Most banks can withdraw your overdraft if they choose to and ask for immediate repayment, so it’s best to stay on top of your overdraft and repay it as soon as you can.
Does having an overdraft affect my credit score?
If you manage your overdraft responsibly and stick within the agreed limit, this can actually have a positive impact on your credit score, but if you’re continuously going overdrawn, and into an unarranged overdraft, this could be detrimental to your financial record.
You can find out more about ways you might be able to boost your credit score in our article Seven steps that could improve your credit score.
Can I switch my bank account if I’m overdrawn?
Yes, you can. While transferring your balance means that you will still be overdrawn in your new account, switching to a bank with lower interest rates could mean that paying back your overdraft becomes a much cheaper process.
We would recommend using the Current Account Switch Service (CASS) in order to make sure your transfer is completed smoothly. You can read more about switching your bank account and the CASS in our article Should I switch my bank account?
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Final thoughts
Overdrafts can be a really useful tool if you need to borrow to cover short term payments or emergencies. However, as the interest rates beyond any free overdraft facility can be eye-wateringly high, you really don’t want to rely on your overdraft too much, or use it to borrow large sums of money. Keeping your balance out of the red is always the best practice if possible.
If you’re worried about managing your debts, our article How to take control of your debts might be of some help.
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