Overdrafts explained

What is an overdraft?

An overdraft allows you to withdraw money from an account that has no funds in it, up to a specified limit. Dipping into your overdraft will put you in debt with your bank but it can act as a safety net for paying off unexpected expenses. It is important to remember that any money withdrawn from your overdraft is a form of credit and is money that you owe to the bank.

There are two types of overdraft:

Unauthorised overdraft – This type of overdraft is an ‘unplanned’ overdraft which occurs when you withdraw more money from your account than your balance permits without agreeing with your bank beforehand. An unauthorised overdraft can also occur if you have an authorised overdraft but have withdrawn more than the agreed limit. If you take out an unauthorised overdraft, you will be charged a higher amount which can leave you in an unstable financial position.

Authorised overdrafts – An authorised overdraft is a borrowing limit that is agreed with your bank before you withdraw from it. You are permitted to withdraw money up to the limit agreed without paying extra charges but there are often some fees required that your bank will disclose to you beforehand.

How do I get an overdraft?

There are a few different ways that you can get an overdraft. When you open a new account with a bank, they may offer you an overdraft as part of the package, but if they don’t, you can apply for one with your bank. The amount available to you in your overdraft will be calculated according to a variety of factors, including your income, credit score and outgoings. There are generally no fees associated with opening an overdraft, but you are likely to incur fees if you use it.

What fees will I be charged with my overdraft?

There are two different types of fees that you will incur if you use your overdraft. They are:

Fixed fees – These are recurring fees that are charged to your account either monthly, weekly, or daily, depending on what you have agreed with your bank. Fixed fees can range from 50p per day to tens of pounds monthly or more.

Interest charges – Interest charges are also known as equivalent annual rates (EARs) and can be set between 0% and 39%. Some banks, if agreed beforehand, will permit you to enter an unauthorised overdraft up to a specified limit with 0% interest, but you must check with them beforehand.

Unarranged overdrafts will incur the same types of fees but with significantly higher rates, so it is important to pay your overdraft charges as soon as possible before they add up. If you enter an unarranged overdraft, you may also be required to pay item fees for any direct debit, withdrawals and other payments taken from your account.

Do you need an overdraft?

It is important to remember that the purpose of an overdraft is to act as a safety net for short term use only. An overdraft can be incredibly useful in emergencies when you are hit with unexpected costs but should not be used as a long-term option. If you are using your overdraft frequently, this could be a sign of a bigger financial issue which needs to be addressed. If you are not sensible with your overdraft usage, this could prove to be costly in the long run.

If you require an overdraft, it is always a better course of action to organise an arranged overdraft rather than dip into an unauthorised overdraft to avoid any failed payment charges. According to the Financial Conduct Authority (FCA), many people do not keep track of their overdraft use which can be a costly mistake.

What is an overdraft buffer?

An overdraft buffer is a limit implemented by some banks that allows you some leeway if you become overdrawn by a certain amount. This buffer is usually quite small but is fee-free and interest-free so if you need to enter your overdraft by a small amount, you won’t be landed with additional charges. If you exceed the buffer, additional charges will incur. If you suspect that you are about to enter your overdraft but have not set up an authorised overdraft with your bank, get in touch with your building society or bank to find out if you are going to exceed your interest-free and fee-free buffer. You can then ask if you can set up a temporary overdraft so that you can avoid any fees.

If you don’t think that an overdraft is the right course of action for you, there are other similar options available, such as credit cards and short-term personal loans.

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