Overdrafts explained

What is an overdraft?

An overdraft works by allowing you to borrow money through your current account. If buying something or taking out money drops your account balance to below £0, you would be seen as ‘overdrawn’, or in your overdraft. Note that this won’t always be possible if you don’t have an overdraft in place. In that scenario, your transaction may be declined if it takes your balance below £0.

You can apply to your bank for an overdraft, where it'll review your income, outgoings and credit score to decide your overdraft limit.

• If approved, you can use your overdraft as a short-term borrowing option and only be charged interest if you use it.

• If you don’t use the overdraft, there are typically no charges.

What can I use an overdraft for?

Overdrafts can be useful as a short-term safety net, allowing you to cover unforeseen expenses or emergencies when you don’t have enough money in your account. For example, if you need to replace a tyre unexpectedly, an overdraft can help you manage the cost until your next payday.

But it's important to be mindful of the risks tied to using an unarranged overdraft. It could lead to higher interest rates and potential negative impacts on your credit score.

How does an overdraft work?

There are two different types of overdraft:

Arranged overdraft

An arranged overdraft is an agreement with your bank that allows you to borrow money up to a pre-approved limit. For example, let’s say your arranged overdraft limit is £1,000 and you have £200 already in your account. If you spent £400, you’d be £200 into your overdraft. This would leave you with £800 of arranged overdraft available.Several banks offer interest-free overdraft buffers, which allow you to go overdrawn by a small amount without being charged interest. These overdraft buffers:

• Can vary from £15 to a couple of thousand pounds, depending on affordability

• Are often set when you open your account

• Can change, for example, if you’re frequently going over your approved limit.

Be sure to regularly check the terms of your overdraft.Some banks may refuse a payment – such as a direct debit or card purchase - that would take you past your agreed overdraft limit. Be aware that you could be charged an unpaid transaction fee each time this happens.

Speak to your bank or building society if you’re struggling to pay off your overdraft or you’re dealing with financial hardship.

Unarranged overdraft

An unarranged overdraft happens when you spend more money than you have in your account and you either:

• Don’t have an agreed overdraft limit in place

• Go over your arranged limit.

Essentially, it's borrowing money from the bank without prior approval. An unarranged overdraft could affect your credit score, making it more difficult to get a loan or credit in the future.

Some banks don’t offer unarranged overdrafts, so they may try to stop payments going out if you don’t have enough money to cover them. But be mindful that not all payments can be stopped, such as offline transactions.

Check with your bank to see if it charges an unpaid transaction fee for payments that would take you into an unarranged overdraft.

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

Do you need an overdraft?

Overdrafts can be helpful for managing short-term funding gaps or emergencies. They’re best used as a temporary solution and shouldn’t be relied on as a long-term financial strategy. Be sure to think about how you plan to pay off your overdraft to avoid any long-term debt.

It’s also worth keeping in mind that overdrafts come with linked costs. 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.

How do overdraft fees and charges work?

From 2020, both arranged and unarranged overdraft fees are included in a ‘flat rate’.

Using an overdraft calculator is a great way to work out how much these rates will cost you, once you either:

• Go over your limit, or

• Start using an unarranged overdraft.

Here's an example of how much being overdrawn £500 would cost you for different lengths of time, from one day up to three months:

Some bank accounts give you an interest-free buffer. If you don’t go overdrawn by more than that buffer amount, you won’t have to pay anything.

What is EAR?

EAR or ‘equivalent annual rate’ is a representative interest rate that you’d pay if you stayed overdrawn on your current account for a year. It doesn’t include any other fees that the bank can charge.

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

On the other hand, dropping into an unarranged overdraft or frequently going over your arranged limit could negatively affect your credit score. Consistently going over your set limits or relying heavily on your overdraft may show lenders that you might be struggling with your finances.

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:

• Track your account via the bank’s app, online or phone banking. Be sure to set up alerts to let you know when you're close to your limit.

• Don't ignore any communications from your bank. Read any letters immediately as they may contain important information about your overdraft.

• Regularly review your overdraft terms and conditions to make sure you’re aware of any changes.

• Avoid using your overdraft for buying any non-essentials. It’s best to give yourself a monthly spending budget and stick to it – any money you manage to save can go towards paying off your overdraft.

• Plan to pay the money back as it’s not your cash and you are ultimately borrowing from your bank or building society.

Paying off an overdraft

Here are some tips on paying off your overdraft:

• Create a budget – look at your income and outgoings to see if there are any outgoings that can be cut, such as eating out regularly. Then use that saved spending to pay off your overdraft.

• Use any savings – if you have any savings, think about using them to reduce or clear your overdraft. The money saved on overdraft interest could be more beneficial than the interest you’d have earned on your savings. This is because overdraft interest rates tend to be far higher than savings interest rates.

• Switch to an interest-free overdraft (if available) – look for overdraft options with lower interest rates. This can reduce the amount you owe in interest, making it easier to pay off your overdraft balance.

• Think about a 0% money transfer credit card – see if you’re able to transfer your overdraft balance to a 0% interest credit card (for a fee). This can give you some time to pay off the debt without building up extra interest. If this option is right for you, make sure you know the terms for keeping that 0% rate. You’ll also need to pass a credit check.

• Talk to your bank – if none of these are an option for you, it’s best to speak to your bank. If you explain your situation, you may be able to come to an arrangement or get advice on how to manage your debt more effectively.

There are more detailed tips in our guide on how to pay off your overdraft.