How does an overdraft work?

What is an overdraft?

An overdraft is when your current account balance goes below zero. An overdraft is a form of credit, and taking out more money than you have in the account means you’re getting into debt – which also means that any money you use from your overdraft is money you owe to the bank.

How does an overdraft work?

An overdraft may be offered to you as part of opening a current account, or you may need to apply for one from your bank account provider. The amount of your overdraft will depend on your personal circumstances, including your credit score, income and outgoings. Usually there is no charge to arrange it, though you will likely incur interest charges when you use your overdraft, with rates often higher than for other forms of borrowing.

Note that not all current accounts have an overdraft facility, so make sure to speak to your provider if this is something you’ll need. Remember too that overdrafts are a form of borrowing, albeit open-ended, which means they don’t have a specific end date when the debt must be repaid. However, they can be recalled at any time, so as with all forms of borrowing it’s important to manage it efficiently and make sure you have a repayment plan in place.

Types of overdraft

There are two types of overdraft: arranged and unarranged.

Arranged overdrafts

Arranged overdrafts, otherwise known as authorised overdrafts, are pre-agreed and allow you to go overdrawn (or borrow) up to a certain limit, charged at a set rate of interest.

Unarranged overdrafts

Unarranged (or unauthorised) overdrafts are not pre-agreed. This may be because you don't have an arranged overdraft at all, or you have gone over your agreed overdraft limit.

In this situation the bank or building society may honour your payments, although they will probably charge you a fee for doing so. Banks can no longer charge more for unarranged overdrafts than for arranged ones, but it could still negatively affect your credit score. If you know you're going to creep into an unarranged overdraft, try contacting your bank in advance to see if you can arrange or extend a temporary arranged overdraft instead.

What is the EAR overdraft rate?

Overdrafts are charged at an equivalent annual rate, or EAR. This is a representative interest rate that shows the rate you would pay if you remained overdrawn for a year. It is determined by:

• The simple rate of interest you are charged if you go overdrawn;
• The frequency with which interest is charged; and
• The effect of compound interest on your debt.

Bear in mind that the equivalent annual rate doesn't take into account any other account fees, which you may also be charged (such as an annual fee).

However, all overdraft providers must now also publish an Annual Percentage Rate (APR) which does include some other fees. You can use the APR to compare overdraft rates more fully, and will see it listed on all advertising for current accounts with overdrafts. You should compare both the EAR and advertised APR before you choose an account.

How do overdraft charges work?

When you dip into your overdraft you’ll be charged an EAR overdraft rate, meaning you could face charges that typically range from 0% up to 39.9%. However, in some cases, banks will offer an interest-free overdraft up to a certain amount, though you must check with your bank if your account has this facility. Unarranged overdrafts will have the same fee structure.

If your current account doesn’t have an overdraft facility, your balance won’t be able to dip below zero and any further payments from your account will be refused. This could likely result in additional charges, so make sure to check with your provider what these will be and plan in advance as much as you can.

Remember too that an overdraft may be removed by your bank or building society at any time without notice. This could leave you with less money than you had planned for and may result in you missing certain payments or incurring additional charges. 

What are the changed overdraft rules from April 2020?

The FCA announced changes to how overdrafts are priced and offered to the public in June 2019. It immediately made banks and building societies ensure that any refused payment fees would correspond to the actual costs of refusing payments. The remaining changes came into force on 6 April 2020 and include:

• Unarranged overdrafts can no longer be priced higher than arranged overdrafts
• A ban on fixed daily or monthly overdraft fees
• A ban on fees to have an overdraft available
• The use of a simple interest rate (EAR)for overdrafts
• Mandatory use of annual percentage rates (APRs) for overdraft pricing on advertising
• More action to identify those who show signs of financial distress and to implement strategies to reduce repeat overdraft usage.

Do you need an overdraft?

One of the most important questions you should ask yourself is whether you actually need to use an overdraft in the first place. Given the high interest rates involved, overdrafts should only be used as a short-term credit option – they can be a useful buffer in emergencies, but when used repeatedly may be a sign of a larger financial problem and could prove more costly than an alternative source of credit.

It’s always better to have an arranged overdraft than to go overdrawn without agreement from your bank. If you find your overdraft balance creeping up or staying the same, month after month, take action and read this guide to repaying your overdraft.

However, if you use your overdraft sparingly and pay it off within a couple of months, make sure your current account is competitive by checking out our selection of the best overdraft current accounts.

Does an overdraft affect your credit score?

Much like all forms of borrowing, an overdraft can have an impact on your credit score – but it all depends on how you manage it. If you only use it sparingly and pay it off quickly, it can potentially help to improve your score as it shows lenders that you can manage credit responsibly. However, if you’re always in your overdraft – or if you regularly dip into an unarranged overdraft and/or have payments refused – it can have the opposite effect, as it suggests you may be struggling to manage your money.

It’s also important to remember that you’re not guaranteed to be accepted for an overdraft in the first place. Your current account provider will need to perform a credit check to determine your eligibility, so if your score needs a bit of a boost, read our guide on how to improve your credit score before you apply.

Can you switch banks if you are overdrawn?

Yes, it is possible to switch your current account while you are overdrawn. You should:

• Compare and find accounts with overdrafts.
• Bear in mind that being accepted for a new bank account will depend on your personal finances and credit score.
• Read more about switching bank accounts.

Current account providers are now required to include tools on their websites to help you assess your eligibility for an overdraft before you apply, making it more likely that you’ll be accepted. Always compare charges for different accounts to make sure that you’ll get a better deal by switching.

What are the alternatives to overdrafts?

Given the high costs involved in overdrafts, it may be better to consider alternative forms of credit. For example, if you dip into your overdraft because of occasional retail spending, consider using a credit card instead.

You get an interest-free grace period of up to two months on a credit card (which you don't get from an overdraft) plus the added benefit of purchase protection on purchases between £100 and £30,000. Just be sure to clear the balance in full and by the payment due date. You could even consider a 0% purchase card for larger purchases and a longer interest-free period.

Alternatively, if you find you are using your overdraft more and more frequently or if you want to make a more significant purchase, then a personal loan may prove to be a more cost-effective way to borrow and pay back your debt in the longer term.