It is estimated that one in 10 UK adults live in their overdraft and are never in the black and over 18 million Brits have strayed into the red in the last year.
With lower interest rates than many credit cards, overdrafts seem to represent a more affordable form of debt. But beware – no matter how you sugar coat them, overdrafts are still debt and, like all debt, should be at best avoided and worst handled with care.
As with all things financial – knowledge is power. Here we take you through the ins and outs of everything you need to know about overdrafts….
What is an overdraft?
An overdraft is an arrangement you make with your bank or building society. They allow you to borrow cash (with interest and fees) through your current account if you are short on funds.
They are generally offered to people who have a regular income being paid into the account – so the bank is assured they will get their money back.
There are two types of overdraft:
- Authorised overdraft: Arranged in advance with your bank. You agree to a borrowing limit and you can spend up to that amount.
- Unauthorised overdrafts: When you spend over your pre-arranged limit without permission. Warning – you will pay hefty charges on unauthorised overdrafts… read on for more information.
How Do Overdrafts Work?
Depending on your bank account and circumstances – you can request an overdraft limit from your bank.
How much you can borrow through your current account will depend on your financial circumstances and monthly income.
Generally, the longer you are a customer with your bank, the higher your borrowing limit because the bank will be able to assess your monthly incomings and decide if you’re likely to pay the money back.
There is no charge to set up an authorised overdraft. But you will be charged interest (rates vary) and a monthly fee only if you
- Go into your overdraft and
- On the amount you have borrowed.
Here’s an example:
- You have a current account with NatWest and a £1000 overdraft limit with an interest rate of 89%EAR (variable) and monthly, one-off fee of £6.
- After your pay cheque has disappeared – you go into your overdraft by £500
- You do not pay the £500 back until your next pay cheque a month later.
- You will be charge £13.76 on your overdraft that month (£6 fee + £7.76 interest).
Overdraft Fees, Interest and Penalties (and how to avoid them)
When you arrange an overdraft limit with your bank or building society, you will be charged a one-off monthly fee (usually around £6) when you go over a certain amount in your arranged overdraft (this threshold depends on your bank).
On top of the monthly fee you will be charged interest on the amount you borrow on your arranged overdraft.
Interest charges vary according to bank and circumstances but are generally between 15% and 20% EAR (Effective Annual Rate) per year.
Now, this is where it gets awkward. If you go over your ARRANGED limit, you are getting into unauthorised territory and will be charged hefty penalty fees.
The vast majority of banks will charge £5 – £10 on unauthorised transactions below £10, while purchases over £30 will generally attract a much higher fee – with some totalling over £40.
So if you spend over the limit – you will pay.
How to avoid fees? There is one simple way – don’t go into your overdraft. And if you have to, do not ever go over your pre-arranged limit.
Do You Really Need An Overdraft?
While many of us rely on our overdraft – it’s not a good idea to use it as your main income.
Remember – an overdraft is debt. The best way to stay out of overdraft debt is to create a monthly budget that you know you can stick to and start building up an emergency fund savings.
Then reduce your overdraft limit with your bank so you know you won’t be tempted to go into it. For more information on creating a budget check out our handy guide on how to budget.
The Golden Overdraft Rule
Most people see overdrafts as an ‘extension’ of their income. This is the wrong way to look at them.
Overdrafts should only be used for emergency situations (such as a one-off, unexpected payment that you weren’t expecting and just can’t cover).
Changing your mindset about overdrafts will help you stay out of debt. So repeat the mantra – only for emergencies beyond my control, emergencies beyond my control, emergencies beyond my control…..and so on. You get the picture.
The best way to overcome emergencies is to have an emergency fund. You can read our handy guide on how to build an emergency fund you can be proud of.
Getting the Best Deal on Your Overdraft
Despite best budgeting intentions, many people find that they are still dipping into their overdrafts.
If you find you are often overdrawn it’s a good idea to shop around for a new current account which offers more favourable overdraft fees than your current bank. So lower fees, interest and penalties.
You can use a comparison tool for bank accounts such as Money Saving Expert’s Top Accounts if you are overdrawn. You may be surprised to find you can negotiate a better rate on your overdraft.
Over to you
What is your experience of overdraft debt? How do you use yours? We’d love to hear from you in the comment box below…!
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