An overdraft – at least one that is pre-agreed with your bank – is designed for short-term borrowing and emergencies. However, many people use it as more than just an occasional buffer.
Rely on your overdraft too often and it could become a very expensive habit.
This article will look at:
- What is an overdraft and how does it work?
- How much can it cost to be overdrawn?
- How can you pay off your overdraft?
- Does being overdrawn affect your credit rating?
- What happens if you can’t pay your overdraft?
Related content: How do overdrafts work?
What is an overdraft?
An overdraft lets you borrow money through your current account. It’s a form of debt and you will likely be charged interest on the amount you are overdrawn. It tends to be a veryexpensive wayof borrowing money.
There are two types of overdraft:
- An arranged overdraft – a limit is organised in advance with your bank. You may be offered one automatically when your apply for acurrent accountor you may have to ask for one.
- An unarranged or unauthorised overdraft – you spend more money than you have in your current account without agreeing with your bank in advance. Either you don’t have an overdraft facility at all or you have gone over your authorised overdraft limit. This type of overdraft is likely to damage your credit score as we explainhere.
Note: Some banks no longer let you go into an unarranged overdraft and will simply decline a transaction instead.
Some points about the costs:
- The interest charge is called the equivalent annual rate (EAR). This is how much your borrowing would cost if you were to remain overdrawn for a year
- Rates vary from 0% to 40%.
- Bank might offer a 0% rate of interest on an overdraft up to a set limit
- Check with your bank if your account has this facility
If you are looking for a bank which offers great customer experience, check out ourindependent ratings.
What sized overdraft will my bank offer me?
The size of the overdraft that you are allowed to take on will depend on your:
- Personal circ*mstances
- Credit score
- Income
- Outgoings
There is usually no charge for arranging an overdraft, but you might have to payinterestwhen you use it.
If you find that you are often in the red, read some of our tips onhow to pay off your overdraft.
How much will it cost to be overdrawn?
Banks can charge up to 40% for an overdraft facility, which is significantly higher than the average credit card rate of 22.76%, according to the Bank of England.
As such, it can work out very expensive if you remain in your overdraft for long periods.
For example, if in one month, you use £1000 of your arranged overdraft for 10 days at 39.9%, you will pay £9.33 in interest. In you spend the entire month (31 days) in your overdraft, the fee will be £28.92.
Some bank accounts do come with a small overdraft for free but check the eligibility criteria carefully. For the best bank accounts for overdrafts, check out our independent ratings here.
Four ways to pay off your overdraft
If you have decided to clear your overdraft, here are four options to consider:
1. Use your savings
If you have money stashed away in a savings account, it may make financial sense to use some of this to clear your overdraft.
It is likely that the rate you are paying on your overdraft debt is much higher than what you are receiving from your savings rates. Paying off more of your debt faster, rather than saving, could leave you better off overall.
Remember, your overdraft can still be there for emergencies if you really need it.
NOTE: You should always consider building a rainy-day savings pot of between three to six months of essential outgoings.
If you are wondering whether to pay off your debt or save, check out our article on the subject here.
2. Switch to a cheaper overdraft provider
Banks are always keen to win new current account customers. Some will offer free cash while others might offer an interest-free period, up to a set limit, on overdrafts.
Investigate whether switching accounts could save you money on overdraft charges. You will also give yourself more time to pay off the debt while no interest is accruing.
NOTE: There is no guarantee you will be offered a cheap or 0% overdraft if you switch banks. All deals are subject to a credit check by the new provider.
If you have any issues on your credit report or have a low credit score, you might not be offered the deal you want.
Moving bank accounts can be a straightforward process, read more about how it works here and which banks are offering account switching bonuses here.
3. Consider a low-rate personal loan
You could take out a personal loan to pay off your overdraft. Borrowing can be quite cheap when compared to the interest you are paying on your overdraft debt.
Depending on how much you want to borrow, you could be paying between 4.9% – 15.1% for a personal loan, according to price comparison website Moneyfacts.
Make sure you compare deals to find the one with the cheapest rate and this will save you money in the long run.
4. Move your overdraft to a 0% money-transfer credit card
A 0% money transfer credit card pays money into your bank account that can be used to clear the overdraft. You are now in debt to your card provider and not your bank any longer.
The difference is that these cards come with an introductory period, of up to 34 months, during which time there is no interest to pay.
The monthly repayments you make to the card provider during that interest-free period go only towards clearing your debt – and not towards interest charges. Find out more about whether it is better to use a credit card or an overdraft here.
Remember:
- Handling fee – there is likely to be an initial outlay of between 1.5% and 4% of the money you borrow
- Varying interest-free period – depending on the provider this can be from 9 months or less to 34 months
- Credit ratings matter – not everyone will get the best rate or even offered the card, the better your credit score the better your chance of being offered the best deals
- Interest-free period is not forever – when the introductory period is over, you will start being charged interest at a high rate on any remaining balance, so you are likely to want to repay it before this date.
If thatis not possible, you could look to apply for another 0% card. Check out the best balance transfer cards here.
Can being overdrawn affect my credit rating?
Yes, being overdrawn can affect your credit score. Your bank or building society will tell the credit-reference agencies each month whether you have used your overdraft – and if so, how much you have borrowed.
A good credit rating is really important because it is one of the pieces of information that lenders will use to decide if you are a good person to lend money to.
If you’re applying for a mortgage, personal loan or credit card, yourcredit ratingcan affect any aspect of the loan, including:
- Interest rateyou are offered
- Size of the credit limit
- Whether you are accepted for a loan at all
You can find out more about credit scores and reports, including ways to improve yours, in our guide here.
If you know that you will want access to borrowing in the future, clearing your overdraft is likely a smart move.
Be aware that if you haven’t pre-agreed an overdraft limit with your bank, you may be blocked from making a payment if it would tip you into the red.
Does applying for an overdraft affect credit score?
If you apply for a current account that comes with an overdraft, the bank or building society will look closely at your credit history (known as a “hard search”).
A hard search will be noted on your credit report and can be seen by other lenders too.It could result in yourcredit scoredipping a few points for a few months.
Several hard searches in a short space of time could be seen by lenders to be a sign that you have financial difficulties because you are suddenly needing to borrow money or your applications are being turned down.
Does increasing your overdraft affect your credit rating?
If you apply for a bigger overdraft, your bank or building society may carry out another hard search of your credit report. Again, this could result in your credit score dipping a few points for a few months.
Using more of your overdraft will push up your total debts and could therefore push down your credit rating. Think of your overdraft as a limit, not a target.
However, it’s far better for your credit rating if you arrange a larger overdraft with your bank, rather than going over a lower limit without asking them.
Should I pay off overdraft or credit card first?
It typically makes financial sense to repay the most expensive debt first to reduce the size of the interest payments you’re making.
It’s likely to be your overdraft that is costing you the most, with many mainstream banks charging interest rates of 40% compared to an average credit card rate of 22.76%.
It’s important to double check the rate you’re being charged so you have accurate information to hand.
Explore reducing the interest on one or both to 0% using a money transfer credit card to cover your overdraft debt and a balance transfer credit card to cover your credit card debt.
Can I pay off my overdraft in instalments?
Overdraft agreements don’t come with any set repayment plan which you would get with a personal loan, for example, so you can pay it off in instalments.
It’s up to you how you clear your overdraft but the quicker you can do it, the less you interest will have to pay in the long run.
You can opt for a lump sum or create your own plan to repay the money using a number of regular instalments.
What happens if I can’t pay my overdraft?
If you’re struggling to repay your debt, contact your bank or building society and ask for support.
They may offer to:
- Reduce or waive the interest on the overdraft for a period
- Transfer the amount you owe on your overdraft to a personal loan that will allow you to repay the debt over time on a reducedinterest rate
- Set up a repayment plan of staged reductions in the overdraft limit (and balance)
If you are not in a position to repay your overdraft, it might be time to speak to a professional.
An adviser at a debt charity such as StepChange, Citizens Advice or National Debtline will go through your debts and wider financial circ*mstances and work out your next move.
The adviser can also deal with the bank on your behalf in some cases, sometimes getting it to freeze interest charges.
Other debt companies offering help will charge a fee; these charities will help you for no charge.
Can you switch bank account if you’re overdrawn?
In theory, you canswitch bank accountsif you have an overdraft, but you will need to arrange this with your new bank as providers have different rules.
A track record of always paying off your overdraft is a good sign for a potential new provider.
However, if they do not agree, you will still need to repay your current overdraft even after you transfer to a new bank account.
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