An overdraft is an extra borrowing facility from a lending institution such as a bank on a current account or debit account once when your account reaches a zero balance.
Banks appreciate that you may need to keep borrowing a little more to pay for a higher bill than expected or sometimes just everyday items that may need more time to repay. But for this convenience, the cost can be significantly more if your bank allows you to borrow more than your limit because you are going beyond what the bank believes you can realistically afford.
It is important to mention that by going into your overdraft, you are technically getting yourself into debt. You should treat your overdraft as a short-term solution to borrowing money, and if possible, for emergencies only.
Types of Overdrafts
You might have to request an overdraft from your bank, which will then be approved or declined. Alternatively, your account may already include an overdraft as part of your agreement – this is common in student bank accounts.
This is an overdraft facility that has been approved by the bank and arranged in advance. By using an authorised overdraft, you have the option to borrow money up to a pre-agreed limit but it will come at a cost. Fees for using an authorised overdraft can be expensive and can cost up to £30 for £100 borrowed, which is around 52% APR. (Source: The Guardian)
Furthermore, you can be charged for just being in your overdraft, with HSBC charging a daily overdraft fee of £5.
Also known as unplanned overdrafts, this is borrowing money from your bank without agreeing the limit with your provider beforehand. This means that if you borrow money without any prior agreement or assessment on what you can afford, the lender is taking on more risk and will charge you significantly more as a result. This should be avoided at all costs where possible.
Unauthorised overdrafts are regularly in the news because they are controversially very expensive. Using an unplanned overdraft can cost as much as £100 for £100 borrowed, equal to as much as 819,00% APR (Source: BBC News)
Even the lowest unauthorised overdrafts are around 1,409% APR which is considered higher than a payday loan when borrowed over the same period.
How Do I Know If I am in My Overdraft?
With most banks who offer an overdraft, your current balance on your online banking or paper statements will show will as a minus (e.g -£346). Whereas when you are not in your overdraft or in credit, your balance will simply be displayed as a positive number (e.g £1,239). Whatever the number is after the minus, is what you owe back to the bank.
If you have -£500 balance and receive a payment of £1,000 into the same account, this will automatically be credited to the amount you owe and your new available balance will be displayed as £500. This is because the minus number is not yours, the amount that it takes to get you into positive numbers will be subtracted to pay back the debt.
Closer regulation of the industry has encouraged banks and providers of overdraft facilities to send SMS notifications to alert customers when they have reached their overdraft or agreed borrowing limit (see image). An example message will advise “you have until 5pm today to clear your account or be charged a fee of £8”.
Is an Overdraft a Good Option For You?
If you already have an overdraft, and find you are dipping into it each month, it is better to have the pre-arranged authorised overdraft and stay within this limit. However, be aware these charges can still add up and overdrafts are an expensive way to borrow in the long term.
Therefore, you should treat your overdraft for short term or emergency purposes only or consider switching to an overdraft-friendly bank account with an interest-free, fee-free overdraft facility.
In addition to the costs, an overdraft isn’t safe for long-term borrowing as it’s not guaranteed and could be withdrawn by your bank at any time. If you need to borrow more than your overdraft allows, or over a longer period, you should consider all the other options available to you.