What is an overdraft?

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If you’ve never had an overdraft, you may be wondering what they are and how they are used. Overdrafts are a common form of credit in the UK, with around 19 million British people using an arranged overdraft each year. However, there are also unarranged overdrafts, which 14 million people use. So, what’s the difference between an arranged and unarranged overdraft and is it bad to borrow through an overdraft?

For something so commonly used by consumers, there’s still a lot that most people don’t know about overdrafts. According to Finder, nearly 9 million of us could be paying fees on our overdrafts that we don’t fully understand.

We’re here to set out the facts about overdrafts and help you decide whether they might be a good option for you.

What are overdrafts?

Overdrafts are a line of credit provided by your bank. They are associated with your bank account and allow you to borrow money, up to an arranged limit. Unlike with short-term loans, you pay interest on the amount you have withdrawn, rather than on the entire limit and it’s usually calculated daily.

It’s a good idea to try to synchronise payments coming into your bank account and payments going out. This will enable you to see what you have left over from your wages each month, after you have covered all the essential costs, such as rent, mortgage, bills and subscriptions.

What are unarranged overdrafts?

Unarranged overdrafts are a form of unapproved credit that you borrow from your bank account provider. You use an unarranged overdraft when you spend more money than you have in your account without previously agreeing on an overdraft facility. You may also borrow from an unarranged overdraft when you go over your arranged overdraft limit.

It’s very easy to go into an unarranged overdraft if you have bills to pay and direct debits scheduled at different times of the month. For example, a payment comes out of your bank towards the end of the month, when you were paid at the beginning of the month. You have already spent most of the money you were paid and the direct debit takes you over your arranged limit or into an unarranged overdraft.

How much do overdrafts cost?

Arranged overdrafts are less costly than unarranged overdrafts. This is because unarranged overdrafts usually carry a fee as well as interest charges. Each bank or overdraft provider charges interest on their overdrafts at different levels. Interest rates for arranged overdrafts range from around 20% to 50% on an annual basis.

Banks are no longer allowed to charge higher rates of interest for unarranged overdrafts, but they can still vary the fees they charge for both types of overdraft facilities. You must check with your bank whether their overdraft comes with a fee or not before you start borrowing.

Remember, overdrafts are regulated along with other consumer financial products and services, by the Financial Conduct Authority (FCA).

What can you use overdrafts for?

The average balance on an arranged overdraft in the UK is £250, while the average amount borrowed from an unarranged overdraft is just £50. This suggests that people do tend to use their unarranged overdrafts minimally, which is good because fees can very quickly mount up when you are being charged up to £5 per day.

Most people use overdrafts sensibly, which means that they only use them over the short term or in emergencies. People often use their overdraft to tide them over until their next payday, when their wages clear their overdraft debt. However, interest charges will start to add up if you are using your overdraft for long periods or struggling to clear your balance when you receive your salary.

How do you get an overdraft?

Most people are either offered an overdraft when they open their bank account, by their bank, or they request an overdraft facility. It’s easy to request an overdraft, you can either:

  • Call your bank on the phone or visit a branch.

  • Ask for an arranged overdraft facility through your banking app or online banking.

Common checks banks may carry out

Banks will carry out some affordability checks on you, to make sure you have a regular income, for example. They may also check your credit history to make sure you don’t already have lots of debts that you are having to service, which may make it more difficult for you to repay your overdraft.

Lending through an overdraft is a reasonably low-risk type of lending for banks to offer as they can automatically collect the repayments as soon as you receive income into your account. However, borrowers still run into problems sometimes, and you can request help from your bank account provider if you are struggling to repay your overdraft or keep up with the interest payments.

Are overdrafts a good alternative to payday loans?

Overdrafts can be a cheaper alternative to payday loans if you can get one. Bank overdrafts can be a good, flexible form of credit for a lot of borrowers. Providing you can afford to clear the overdraft quickly and use it sensibly, it may cost you very little - especially if you have a fee-free overdraft from your bank.

However, if you run up a large overdraft and fail to clear in over months or even years, you are likely to face much larger costs than you would ever have to pay when taking out a short-term loan with a finite repayment date and capped fees and interest charges.

The issue for many borrowers is that they are struggling to get an arranged overdraft from their bank because they do not meet the required criteria. Banks are relatively strict on offering overdrafts and, being banks, they often have a traditional view of lending, which can leave those of us with less-than-perfect credit records struggling to access cheap forms of credit.

The benefits of payday loans

If you’re looking for alternatives to overdrafts, we’ve outlined some of the benefits of payday loans:

  • Online lenders offering short-term loans are often more open to lending to those with sub-optimal credit histories.

  • Short-term loans and payday loans offer quick access to small amounts of credit.

  • Interest rates are high, but the market is now heavily regulated to prevent borrowers from building up unsustainable levels of debt or taking out loans that they cannot afford to repay.

The right kinds of short-term credit for you will heavily depend on your financial circumstances. If you are employed and have a decent regular income and a good credit rating, an overdraft, if handled correctly, may offer you the best value credit. However, if you have struggled to get an overdraft from your bank due to your credit rating or level of income, you may be able to find and short-term lender online that offers you a better option.

Remember, it’s important to do your research and consider all your options before signing up for any form of credit agreement, however informal it may seem. As soon as you have gone into your overdraft, you are in debt, and it is costing you money.

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