About 1 in every 5 people in the UK has an overdraft facility on their current account. And we are relying on them more than ever: the overdraft usage has increased by 7.1% between August 2021 and December 2022. Overdrafts can turn into a serious financial undertaking, so it's important to understand how they work and the associated fees before tangling yourself in debt.
How Do Overdrafts Work?
An overdraft is a form of credit given to customers by their banks, allowing them to draw more money than the amount available in their account. It works like having a flexible line of credit available and can be used for short-term cash flow solutions or emergencies. Once you set an overdraft limit with your bank, you are able to withdraw up to this limit at any point, with the option of paying it back in full over an agreed period.
It is important to note that not all types of bank accounts come with an overdraft facility and some customers must apply for it separately. When an overdraft is approved, a limit will be set by the bank and the customer can spend up to this limit without any additional charges. Once the limit is exceeded, extra fees or interest may apply depending on how long the overdrawn funds remain unpaid.
However, some banks in the UK may provide an interest-free overdraft or offer one for a set period of time. The terms may vary from bank to bank, so it’s important to read the fine print or enquire before signing up.
Overdrafts can make or break your credit score
An overdraft is a revolving credit line that generally doesn’t affect your credit score – especially if it is an arranged overdraft. Yet, if you are consistently using an overdraft and unable to pay it back, this could lead to missed payments or defaulting on the amount owed. Doing so can lead lenders to consider you a higher risk, especially if you use your credit card for overdraft protection, and can ultimately impair your credit score.
You can avoid this simply by paying off your overdrafts on time. Being timely on your debts as such implies that you are responsible with your credit and can manage it responsibly – which could, in fact, help improve your credit score.
Does applying for an overdraft affect your credit score?
When you apply for a current account that includes an overdraft, the bank or building society will conduct a thorough review of your credit history, which is known as a "hard search." This inquiry will be recorded on your credit report and can be viewed by other lenders as well. It may cause your credit score to decline slightly for a few months.
If you undergo multiple hard searches within a brief period, lenders may interpret it as an indication that you're experiencing financial problems since you're unexpectedly seeking credit or your applications are being rejected.
Are you eligible for an overdraft?
The following criteria usually determine whether you are eligible for an overdraft;
You need to be aged 18 or over and a UK resident,
You shouldn't have any county court judgements against you in the last few years (the timeframe varies by individual banks),
If you've been declared bankrupt recently, you may not be eligible (terms and conditions vary by individual banks),
Most banks will enquire whether you've fallen behind any credit payments in the last few months. If you have, you may not be eligible,
Most banks require you to have a regular income,
And finally, you should have a good credit score.
Credit rating agencies have five categories for credit scores: excellent, good, fair, poor, and very poor. Each credit rating agency (CRA) uses a different scale to determine your credit score. While they can vary, differences are usually minute – meaning that if one CRA deems your credit score fair, it’s likely that others will too.
Here’s what scores look like from each of the UK’s three largest CRAs:
| Equifax | TransUnion | Experian | |
|---|---|---|---|
| Fair | 380-419 | 566-603 | 721-880 |
| Good | 420-465 | 604-627 | 881-960 |
| Excellent | 466-700 | 628-710 | 961-999 |
Types of Overdrafts
There are two main types of overdrafts: authorised overdrafts and unauthorised overdrafts.
1. Arranged overdrafts
An arranged, or authorised, overdraft is a type of overdraft facility that you have agreed with your bank or lender and has their approval. The key here is that they're arranged and agreed upon before you overdraw from your account.
For example, say that your arranged overdraft limit is £10,000 and your current balance stands at £2,000. If you spend £7,000, you'd be £5,000 into your overdraft. This would leave you with £5,000 of your arranged overdraft available.
Authorised overdrafts are generally interest-free as long as the amount borrowed remains within the pre-arranged overdraft limit. However, the bank or lender may charge a fee for setting up and maintaining the overdraft, as well as other fees, such as penalty charges, if you exceed your overdraft limit or take out more money than you have agreed.
The amount of wiggle room banks give for an arranged overdraft varies widely from as low as £15 to a couple of hundred pounds.
2. Unarranged overdrafts
An unarranged, or unauthorised, overdraft is one that has not been agreed upon with your bank or lender. This type of overdraft occurs when someone withdraws more money than what is available in their account without the approval of their bank and may be subject to a high interest rate and charges for going over the limit.
Going into an unauthorised overdraft may end up being reported to credit reference agencies, and can damage your credit score.
Along with Prudential Regulation Authority (PRA), the Financial Conduct Authority (FCA) is the main body regulating banks based across the country. Back in 2020, the FCA released two separate measures to combat the mismanagement of overdraft facilities: ultimately, it simplified overdraft charges and addressed hefty unarranged overdraft fees. As a result, the measures have saved people across the UK a whopping £1 billion in total.
Overdraft Fees
Banks charge a flat rate for both authorised and unauthorised overdrafts. It is usually charged as a percentage of the total overdrawn amount and varies from one bank to the next, depending on the length of time overdrawn. But don't fret – most banks have in-built overdraft cost calculators on their websites to help you understand how much the overdraft fees are going to cost.
Note that banks can charge up to 40% for overdraft facilities, which is significantly higher than the average for credit cards (26.7%).
What is EAR?
The annual equivalent rate (EAR) is used to calculate the overall cost of an overdraft in terms of interest. The EAR represents how much it would cost if you had borrowed for a year at the same rate. It is important to understand your bank's overdraft fees associated, so be sure to check your agreement before signing up for any products or services.
Here's an example of the costs of having an overdraft of £1,000 for different lengths of time, from day 1 to day 30.
Length of time overdrawn | Interest Charges |
|---|---|
1 day | £0.91 |
7 days | £6.37 |
14 days | £12.73 |
21 days | £19.10 |
30 days | £27.29 |
(Source: HSBC)
Managing Overdrafts: Tips and Suggestions
It’s a national habit: Britons turn to overdrafts heavily, and not even as a last resort. According to a YouGov study, in a year where the nation was overdrawn to the tune of £3.5 billion, the first day Britons used their overdraft was the eighth day of the month on average.
If you feel stuck in a rut because of an overdraft, here are some top tips and suggestions to help you manage your situation better. First off, take personal measures to tackle the issue.
Monitor your bank account: The first step to avoiding overdrafts is to keep a close eye on your bank balance. Most banks now offer mobile apps and even instant spending notifications, so you can check your balance in real-time and make sure you never go into the red. You can take this a step further by setting up an automated alert when your account balance goes below a certain amount – this is a popular feature among digital banks.
Pay attention to due dates: Make sure you check the due date for any bills or payments that are coming out of your bank account and plan accordingly. This can help you avoid accidentally missing payments or going over your overdraft limit.
Use budgeting tools: Setting up a budget is one of the best ways to stay on top of your finances, and there are plenty of budgeting apps available that can help you do this. These tools allow you to track spending and set financial goals, which can help you keep on top of your money management (for those who are deliberating, we compared Starling and Monzo side by side). An app like Notion can help you keep a running total of your income, expenses, and overall financial picture. Or, alternatively, online-only banks like Monzo or Starling have versatile, in-built budgeting and saving tools that can help you stay on top of your expenses.
Consider switching banks: If you're constantly struggling with overdraft fees, it may be worth considering moving to a bank that offers better rates for overdrafts. Look into the different accounts on offer and compare the interest rates and overdraft charges to find one that's right for you.
Talk to your bank: Most banks will have advisors who can advise you on how best to manage your finances and pay off any overspending. This could include setting up an interest-free overdraft or negotiating repayment plans. It's always worth having a conversation with them to see what options are available before taking out an overdraft.
Overdraft protection can be your last resort
Overdraft protection is a service offered by some banks and lenders to help protect customers from costly overdraft fees. When your current account runs low on funds, the bank or lender can automatically transfer an agreed amount of money from the linked line of credit to cover any purchases made with a debit card.
The main advantage of using overdraft protection is that it keeps you from having to pay any additional fees for going over your limit. Yet, the catch is that there may be costs associated with setting up and maintaining the service, as well as interest charges depending on how long you remain in overdraft.
Generally, you need to apply for overdraft protection or request that the service be added to your account. Your eligibility depends on the institution and your creditworthiness. Note that not all banks provide overdraft protection, but many do, including HSBC, Santander, NatWest and Barclays. The terms and conditions for these services vary from bank to bank.
An example of overdraft protection
If you have overdraft protection, you can spend £1,000 even if you only have £650 left in your overdraft. The bank could charge a transfer fee of £15 and transfer funds from a linked credit card, line of credit, or savings account to cover the difference. This means that you would now have a balance of £635 (£650 - £15) in the account as well as a charge of £1,000 to pay off on the linked line of credit.
To keep your finances in check, it's best to avoid using overdraft protection as an excuse to spend more than you can afford. It should just serve as a safety net in case you accidentally overdraw your account.
Should you use it?
Now that you understand what overdraft protection is and how it works, let’s take a look at some of the advantages and disadvantages associated with this service;
- You can avoid damaging your credit score — Going over your limit when you don't have overdraft protection may lead your bank to report you to credit reference agencies, which could negatively impact your credit score. With overdraft protection, this isn't an issue since any money withdrawn over the agreed limit is covered by the linked line of credit.
- You can avoid overdraft charges — Overdraft protection allows you to avoid costly unarranged overdraft charges since any amount that is over your limit is covered by the linked line of credit.
- You can manage large purchases — The idea of having to put a large purchase on hold simply because you don’t have enough money in your account can be frustrating, but overdraft protection can help you manage these purchases by automatically transferring the extra funds needed.
- The recipient is not informed — The bank doesn't inform the recipient of your payment that you are using overdraft protection. This means that you can make payments or write cheques without the other party knowing that you don't actually have enough in your account to cover it.
- There may be fees associated with setting up and maintaining the service — Depending on the bank or lender, there may be costs associated with setting up and keeping the overdraft protection in place.
- You may be offered a poor deal — Depending on your credit score and the institution, you may be offered overdraft protection with high interest rates or unfavourable terms, so it's important to shop around for the best option before deciding.
- Your credit limit may differ from your overdraft limit — When applying for overdraft protection, you must specify how much of a line of credit you need; this is important as your credit limit may differ from your overdraft limit.
- It could encourage overspending — Making payments when there isn't enough money in your account can make it easy to overspend and rack up debt. Considering that, you need to be aware of the risks associated with overdraft protection and make sure that you can afford any payments or purchases before making them.
Paying off your debts
The best part of taking an overdraft is paying it off. Here are a few tips to help you out:
Make a plan: Before tackling your overdraft, take a look at all of your expenses and see what can be cut back or eliminated in order to free up more funds for repayment. Set yourself a budget and keep track of your progress. Being intentional with how you manage your finances will help you pay off the overdraft faster.
Make more than minimum payments. It's important to make repayments that are higher than the minimum amount required by your bank. Provided that you can stay within your budget, making larger payments each month will reduce your balance more quickly.
Repay the balance using credit with a lower interest rate: While borrowing more money isn't the ideal solution, it may be worth considering transferring any overdraft balance to a credit card with a lower interest rate. This could help you pay off your balance quicker and save on interest.
Contact your bank: If you're struggling to make payments or would like to discuss different repayment options, don't hesitate to get in touch with your bank. They should be able to provide advice and assistance so that you can stay on top of your finances.
Final Thoughts
We've all faced a time when our finances have been tight, and an overdraft can provide a bit of breathing room to help you get through the tough times. It can be a helpful tool when managed wisely, but it's important to be aware of the risks and make sure you know exactly how you'll pay off any balance.
Before taking out an overdraft, look into the different interest rates and fees associated with it and make sure you're comfortable with the terms. Be strategic about your debt management — make a budget and track your spending. With careful management, an overdraft can be a valuable tool in handling your finances.
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