How does an overdraft work?
Do you know how an overdraft works? Latest Deals is here to help you understand everything you need to know about overdrafts and how to use them to best suit your interests.
If you have a standard current bank account in the UK, you could apply for an overdraft that allows you to borrow money on a short-term basis.
What is an overdraft?
An overdraft is a type of loan and, therefore, a debt. An overdraft can be positive or negative depending on how you use it, and there are smart ways to do it.
An overdraft allows you to borrow extra money through your current account. Typically, you will need to apply for an overdraft and agree on an overdraft limit with your bank. These are called authorised or planned overdrafts. But sometimes, you can experience an unauthorised or unplanned overdraft. We will talk more about this later on in this guide.
How an overdraft works can change depending on your bank. But, if you use an overdraft, you will usually pay interest on it, and that’s why sometimes it can be dangerous to start depending on overdrafts to make ends meet.
Types of overdraft
There are two types of overdrafts: authorised overdrafts (also known as planned overdrafts) and unauthorised overdrafts (also known as unplanned overdrafts).
With an authorised overdraft, you agree to a limit with your bank and can spend up to that amount.
With an unauthorised overdraft, you don’t have an agreement with your bank, and if you go over your spending limit or don’t have enough money to cover a direct debit or standing order, your bank could provide this overdraft. This changes from bank to bank.
Since April 2020, the Financial Conduct Authority (FCA) has changed how overdrafts are priced and offered to the public.
At the moment, banks are not allowed to charge higher fees for unauthorised overdrafts.
In addition, banks can only charge a single annual interest rate (APR) on authorised overdrafts so that you can compare charges between bank accounts at different banks.
At the moment, you can find interest rates on overdraft facilities ranging from 0% to 40% or more.
IMPORTANT NOTE: When you choose a current bank account with an overdraft, make sure you pick the one with the lowest interest rate.
Who is eligible for an overdraft?
Overdrafts are not available for everyone. You must be aged 18 or over and a UK resident. You also can’t have any county court judgments for the last few years, no bankruptcy in recent years and no missed credit payments in the last few months.
Banks want to make sure you have the means to pay back any debts you might accumulate with the overdraft.
IMPORTANT NOTE: You may get a county court judgment (CCJ) if someone takes court action against you (saying you owe them money) and you do not respond. Learn more about this here.
You can apply for bankruptcy if you cannot pay your debts. Learn more about this here.
Do you need an overdraft?
As mentioned above, overdrafts can be positive or negative because it depends on how you use them. If you are going to use them responsibly, it could help you make ends meet with more ease. Getting an overdraft could help you to avoid fees for returned payments, for example.
IMPORTANT NOTE: It’s important to remember that an overdraft is a short-term solution and shouldn’t be used if you want to spend more than you can afford.
Advantages of overdrafts
There are some advantages to using overdrafts. Below, you will find some of them:
- It’s more flexible than a loan, as you can pay it back when you can. When you get a loan, you must pay back the money on a set date.
- It’s quicker to apply for overdrafts than for a loan. Usually, you can apply for one simultaneously when you apply for your current bank account. Or, if you already have an existing bank account, you can easily apply for an overdraft. We will teach you how later on in this guide.
IMPORTANT NOTE: If you need a quick solution to fix a one time kind of situation where you see yourself unable to make ends meet, getting an overdraft could be very helpful.
Disadvantages of overdrafts
There are some disadvantages to using overdrafts. Below, you will find some of them:
- Usually, you can borrow less money than you would with a loan.
- Usually, it comes with higher interest rates than other types of loans.
- An overdraft could lead you to overspend, as you will have access to more money than you have, giving you the impression that you can afford more things than you actually can.
- You could end up with a large overdraft that’s hard to pay off.
IMPORTANT NOTE: Overdrafts are not a long-term solution for your financial problems, as they can only make them worse over time if you don’t cover your overdrafts at the end of the month. If you have the habit of overspending, we have a guide that could help you learn how to budget.
How do I apply for an overdraft?
You can apply for an overdraft during your bank account application. We have a complete guide to teach you how to open a bank account in the UK.
If you wish to apply for an overdraft with your existing bank, you can usually do this via the mobile banking app, online banking, over the phone, or in-branch, whichever you prefer.
The process is pretty straightforward, and you need to follow your bank step by step. Usually, your bank will give you an answer within a couple of days. They will check if you have any county court judgments for the last few years, bankruptcy in recent years and missed credit payments in the last few months.
Cancelling or reducing your overdraft limit
If you apply for an arranged overdraft and then change your mind, you have 14 days from the date the overdraft was provided to cancel it. You can also reduce your overdraft limit at any time.
Increasing your overdraft limit
You can also increase your overdraft limit at any time, as long as your bank approves it. You can do this by phoning your bank, visiting a branch, or via internet banking.
6 Tips for controlling your overdraft
Tip #1 Keep an eye on your account balance.
Ideally, you should check your account balance every day, or at least every week, to know what’s going on there. Then, you know how much you are spending and if you need to cut some spending back to make sure you can cover all your living expenses. Also, it’s essential to stick to a budget. With one you will have even more control over your finances. Learn here how to create a budget.
Tip #2 Keep reading your bank’s letters.
If your bank sends you a letter, it’s important to keep reading them, as they could tell you about a change of your overdraft limit or an increase in your overdraft interest rate.
Tip #3 Use savings if you have them.
If you have savings, you could use them to cover an unexpected expense instead of going into overdrafts because overdrafts come with interest, so you will be paying more to cover your expenses.
Tip #4 Switch banks.
You could switch bank accounts to get access to lower interest rates and overdraft charges. It’s important to see what is available on the market. Learn how to switch bank accounts here.
Tip #5 Talk to your bank if you think there is a problem with your overdraft charges or if you can’t manage to pay your overdraft.
If you think there is a problem with your overdraft charges or can’t manage to pay your overdraft, talk to your bank and let them know what the problem is. Keeping an open dialogue with your bank and facing any issues will make dealing with them much more manageable.
What if I’m struggling to pay my overdraft?
If you’re struggling to pay your overdraft, contact your bank and ask for support. They could reduce or waive the interest charge for a period, they could transfer the amount you owe on your overdraft to a loan that will give you more time to pay, or they could set up a repayment plan of staged reductions in the overdraft limit.
Tip #6 Don’t count on overdrafts because they can be taken from your account anytime.
An overdraft is not guaranteed, so your bank could take it away at any time.
IMPORTANT NOTE: If your overdraft was taken without your knowledge, and you were charged fees for returned payments, you can complain to the Financial Ombudsman Service.