Overdrafts explained

An overdraft can be a great safety net for emergencies or necessities. Thinking about getting one? Check out our guide on what you need to know.

An overdraft can be a great safety net for emergencies or necessities. Thinking about getting one? Check out our guide on what you need to know.

Anelda Knoesen
From the Money team
8
minute read
Do you know someone who could benefit from this article?
Posted 13 OCTOBER 2020

What is an overdraft?

An overdraft is when you agree with your bank that your balance can go below zero up to a set limit. This allows you to withdraw more money than you have – meaning that you now owe the bank money.

When you go into your overdraft you’re getting into debt, so it should only be used for short-term borrowing or emergencies. It’s important you manage your overdraft to avoid damaging your credit score.

How does an overdraft work?

An overdraft allows you to borrow money through your current account. You have to apply for an overdraft and it has to be approved by the bank. Your bank will agree on an overdraft limit, depending on your income and outgoings, as well as your credit score. This agreed limit is your arranged (or authorised) overdraft.

There’s usually no cost involved in putting the overdraft in place. If you don’t use it, then you won’t be charged for having it.

How is an overdraft useful?

Overdrafts can be useful if you’re temporarily short of money. For example, you get a puncture and need to replace a tyre – you haven’t budgeted for this, so you use your overdraft to tide you over until payday.

What are the different types of overdraft?

Arranged overdraft: This is agreed by your bank. You’re entitled to go into your arranged overdraft up to the agreed amount. For example, if your arranged overdraft limit is £1,000 and you have £200 in your account but spend £450, you’d be £250 into your overdraft. This would leave you with £750 of arranged overdraft available.

Several banks offer you some wiggle room on your account for free. These interest-free overdraft buffers can vary from £15 to a couple of hundred pounds and will usually be set when you open your account, but may change as your circumstances change.

Unarranged overdraft: If you go over your arranged overdraft, or you go overdrawn without having an arranged overdraft, then you’ll be in unarranged (or unauthorised) overdraft territory.

Higher interest rates used to be charged for unarranged overdrafts, but since April 2020 this is no longer the case. Arranged and unarranged overdrafts are now charged at a single rate of interest, and there are no monthly or daily fees for being overdrawn.

But an unarranged overdraft could mean you pay a fee for any transaction you make – like withdrawing cash or making card payments. And if a direct debit or standing order payment bounces because there are insufficient funds in your account, your bank can also charge a fee for a refused payment.

An unarranged overdraft could also affect your credit score, making it more difficult to get a loan in the future.

Do you need an overdraft?

Because of the cost of overdrafts, it’s probably worth using yours only for short-term funding and emergencies. If you’re likely to be overdrawn for any length of time, it might be worth looking at another type of credit - for example, 0% credit cards.

What are the recent changes to overdrafts?

In April 2020, the Financial Conduct Authority (FCA) introduced major changes affecting how banks can charge for overdrafts. Under the new rules:

  • banks can only charge a simple effective annual rate (EAR) of interest, without additional fees and charges
  • the same interest rate is charged for arranged and unarranged overdrafts
  • there's a ban on monthly or daily fees for being overdrawn
  • banks must publish the annual percentage rate (APR) on their overdrafts, making it easier for customers to compare charges between accounts

Although the new rules have made comparing overdrafts simpler, it could mean that customers who previously benefited from a lower interest rate may be worse off. Interest rates on overdrafts tend to range from 19% to 40%. A single overdraft rate across all current accounts could mean some people end up paying more for their authorised overdraft than they did before.

Whether or not the changes mean that your overdraft will be more expensive could depend on how often you use it. With no monthly or daily fees to pay, it might not be more expensive if you only use it occasionally. But if you’re constantly using your overdraft throughout the month, you could end up paying more.

If you’re concerned about the changes and how they’ll affect your overdraft, talk to your bank. They can evaluate your overdraft and, if you’ll be worse off, may be able to offer a cheaper way of clearing your outstanding balance. The FCA states that under the new rules, banks must be willing to support and offer practical help to customers who are worse off and vulnerable because of the changes.

Overdraft changes due to coronavirus

At the start of the pandemic, the FCA set out guidelines for banks offering temporary support and help for customers struggling financially due to COVID-19.

Those facing financial difficulties because of the pandemic could apply for an interest-free buffer of up to £500 for three months, on an arranged overdraft on their main current account. If the overdraft was higher than £500, some banks offered a lower interest rate for the buffer period. In June, payment holidays were extended for a further three months.

If you’re struggling financially because of coronavirus, you have until 31 October 2020 to apply to your bank for this temporary payment freeze support.

With the interest holiday and its extension coming to a close at the end of October 2020, banks and building societies are starting to revert to their business-as-usual interest rates for overdrafts – which can be up to 40%. This means that costs on your overdraft could rapidly increase.

Some banks are still capping the maximum you can be charged on your overdraft, until the end of October – for example, Barclays will charge you a maximum of £90 a month. Check with your bank to work out what your situation is, and if and when the overdraft rate will change if it hasn’t already.

Meanwhile, as rates are beginning to go back to normal, the FCA has given banks and building societies new advice on how to deal with overdrafts. Instead of a blanket £500 overdraft, your bank is now expected to offer personal, tailored help. This can include:

  • Working with you to provide support before you miss payments, as you get towards the end of the buffer period
  • Acknowledging and responding to the needs of vulnerable customers
  • Allow you time, without pressurising you into repaying your debts within an unfairly small amount of time
  • Establishing robust and realistic repayment arrangements which are affordable and take into consideration your whole financial situation, including any other debts and your necessary expenses for living
  • Being flexible and employing a full range of shorter and longer-term options to support you, to lessen feelings of stress and anxiety because of your financial difficulties
  • Stopping customers’ balances from increasing sharply by reducing, suspending, cancelling or waiving any interest, charges or fees required

If you need help getting to grips with your overdraft and getting yourself back in the black, talk to your bank or building society to see if they can offer any of these options to help you.

John Crossley,

Head of Money at comparethemarket.com

“There is no doubt that current account providers offered many households a lifeline by providing interest-free overdrafts during the height of the pandemic. However, overdraft interest rates have slowly but surely been creeping back up as lockdown continues to ease and the economy struggles to get going again.

“Many households will still be under financial strain and in need of funds to help tide them over. Indeed, our Financial Confidence Tracker shows that nearly a fifth of people struggled to pay their bills at the start of August. If you wish to extend the payment exemption on your overdraft, make sure you get in touch with your provider.

“When overdrafts return to the 39% level, it becomes an expensive way to borrow. Responsible borrowers could consider applying for a credit card as it can be a cheaper form of debt, although be aware that providers have tightened eligibility criteria recently.

“If you’re unhappy with the overdraft fees your bank is charging, it’s worth finding a more competitive provider, or considering a cheaper alternative if you need to take out credit.”

Can I switch banks if I’m overdrawn?

Yes, it’s possible to switch banks if you’re overdrawn, but banks will most likely assess your personal finances and credit score before accepting your application. Banks also include tools on their websites to help you assess your eligibility for an overdraft with them before you apply.

Before you make the switch to a new bank, shop around by comparing current accounts with overdrafts. As well as the EAR, check out the charges and rules for each account to ensure you’re getting a deal you’re happy with. Using our price comparison tool, you can start comparing current accounts in minutes.

What are overdraft fees and charges?

Now that the FCA has done away with monthly and daily charges, both arranged and unarranged overdraft fees are included in a ‘flat rate’.

For example, at the time of writing (October 2020), HSBC, Nationwide and M&S Bank charge a flat fee of 39.9% EAR, with NatWest close behind at 39.49%. Barclays is currently offering an annual interest rate of 35%. App-based bank Monzo has switched from a fixed 50p a day fee to an EAR of 19%, 29% or 39%, depending on your credit score.

Can my overdraft be removed?

One reason why an overdraft isn’t recommended for long-term borrowing is that it’s not guaranteed. Your bank can remove your overdraft at any time, without notice. This could mean that any cheques or direct debits go unpaid – and you then can be charged additional fees for bounced payments. That’s why it’s important to keep track of your current account and spending.

However, if the bank removes your overdraft without warning and you’re charged, you may have grounds to complain. If you aren’t satisfied with your bank’s response, you can take your complaint to the Financial Ombudsman Service.

How do I check my overdraft?

The best way to keep an eye on your overdraft and spending is to regularly check your current account. You can do this by:

  • downloading the mobile banking app provided by your bank
  • setting up a text alert for when your balance is getting low
  • making sure you read any letters from your bank straight away

How do I extend my overdraft?

Most banks will give you the option of extending an existing overdraft. In many cases, you can do this yourself via the bank’s mobile banking app, over the phone or at your local branch.

Does using an overdraft affect my credit rating?

An overdraft will show up on your credit report as a debt so, yes, it will have an impact on your credit rating.

But if you stay within the limit and make regular payments, an arranged overdraft could help improve your credit score. Regularly clearing your overdraft shows lenders that you’re a reliable borrower.

An unarranged overdraft, however, could be a red flag. It shows lenders that you might be struggling with your finances and this could have a negative impact on your credit score. Going over your limit and constantly dipping into your overdraft could also damage your credit rating.

Can I get an overdraft as a student?

Yes, you can. In fact, many banks offer favourable, authorised overdraft conditions for student accounts. Many offer UK students an interest-free arranged overdraft of up to £3,000. Of course, that’s assuming you keep within your limit and you’ll be able to pay it back once you’ve completed your studies.

Top tips for managing your overdraft

It’s vital that you stay in control of your finances when managing an overdraft. Here are our top tips for staying in the black.

  • Regularly track your account via the bank’s app, online or phone banking.
  • Read all letters from your bank immediately – they may contain important information about your overdraft.
  • If you have any savings, it may end up cheaper using them to pay off your overdraft.
  • Give yourself a monthly spending budget and stick to it – any money you manage to save can go towards paying off your overdraft.

What are the alternatives to an overdraft?

If you use your overdraft for occasional spending, a better alternative might be a 0% purchase credit card. This can give you a fixed length of time to pay off the debt gradually without paying interest.

For longer-term borrowing and larger purchases, you might want to consider a personal loan. Repayments are spread over a fixed period of time and are usually for a fixed interest rate, which can help you budget.

Compare current accounts

Use our comparison tool to compare current accounts across the market, taking into consideration whether an overdraft is something you might need and something you’re able to pay off. 

Compare current accounts

Compare now
Compare current accounts quickly and easily Compare now

comparethemarket.com uses cookies to offer you the best experience online. By continuing to use our website, you agree to the use of cookies. If you would like to know more about cookies and how to manage them please view our privacy & cookie policy.