An overdraft can be a useful way to cover short-term expenses when your bank balance is low. An overdraft is like a short term loan from your bank that lets you keep spending even when your balance hits zero. It allows you to borrow money through your current account, but it often comes with interest charges or fees.
As of April 2024, studies found that 30% of Britons used their overdraft at some point each month over the past year. This suggests that overdraft usage is a financial tool used by people, often towards the end of the month or just before payday.
Before relying on an overdraft, it’s important to know how it works and whether it’s the right option for you.
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What is an Overdraft?
An overdraft lets you take out more money than you have in your current account or business bank account. Your bank decides a limit on how much you can borrow, called your overdraft limit. This limit depends on your credit history, income, and what you can afford.
Banks usually charge interest on the money you borrow through an overdraft. However, some offer interest-free overdrafts, which let you borrow a small amount without paying extra.
For example, if you have £1,000 in your account and a £500 overdraft limit, you can spend up to £1,500. You’ll pay interest on any money you borrow beyond your balance. If you go over your overdraft limit, you may enter an unarranged overdraft. This can give you extra money but may also lead to more charges.
Let’s understand the advantages and disadvantages of bank overdrafts.
Advantages of using overdrafts
An overdraft lets you borrow money directly from your current account when your balance is low. It can be a handy way to cover unexpected costs. Here are some key benefits of using an overdraft:
1. Simple to set up
Getting an overdraft is usually quick and easy. You apply through your bank, where they check your credit history and existing debts, before deciding how much you can borrow. Some banks even offer an interest-free buffer, meaning you can borrow a little without paying extra fees.
2. Flexible borrowing
Unlike loans or credit cards, an overdraft gives you access to extra money whenever you need it. There’s no need to apply each time, you can dip into it when your balance runs low.
3. No charges for early repayment
With some loans, repaying early can come with extra charges. But with an overdraft, you can pay it off whenever you like without penalty. This means you only borrow for as long as you need, helping you manage your money better.
Disadvantages of using overdrafts
An overdraft can be helpful, but it also comes with some disadvantages. Here are a few things to watch out for:
1. Low borrowing limits
Overdrafts give you quick access to extra cash, but the amount you can borrow is usually small. Unlike a loan, an overdraft won’t cover big expenses, like buying a car or making home improvements.
2. High interest rates
Overdrafts can be expensive. Banks charge interest on the amount you borrow, sometimes as high as 40%. In 2020, the Financial Conduct Authority (FCA) addressed high overdraft rates. Today, overdraft interest rates typically range from 19% to 40%.
If you want to estimate your overdraft cost, you can use an overdraft calculator.
3. Your bank can lower or cancel your limit
Your bank controls your overdraft limit. They can lower it or even cancel it if your financial situation changes, such as if your account balance stays low for too long. If you rely on an overdraft, losing access to it could leave you short on cash.
4. The risk of always being overdrawn
It’s easy to fall into the habit of relying on an overdraft. Since it’s linked to your bank account, you might not even think of it as debt. But if you don’t pay it back, interest keeps adding up, making it harder to get out of the red. This cycle could be seen as the overdraft affect.
According to consumer credit insights revealed by the FCA, consumers often do not see overdrafts as debt. They quickly become used to using them. The research also showed that overdraft users do not actively repay their overdraft. Most repayments are just funds coming into their bank accounts, like your monthly wages.
5. Unauthorised Overdrafts
If you spend more than your arranged overdraft limit, you’ll enter an unauthorised overdraft. This can happen if a bill or direct debit goes through when you don’t have enough money in your account. Banks will charge the same interest rate as an arranged overdraft for this. Using an unauthorised overdraft too often may harm your credit score.
To avoid these risks, always check your account balance and try to use your overdraft only when necessary.
Are there alternatives for overdrafts?
After weighing the pros and cons, you might decide an overdraft isn’t the best option for you. There are other ways to borrow money, especially for short-term needs.
- Short term loan: If you need money for a short period, a short term loan could be a good option. These loans are usually repaid within a year and can be useful for covering unexpected expenses. They require a separate application but are often available on short notice.
- Credit card: A credit card can be an alternative to an overdraft for everyday expenses. Some credit cards offer low interest rates or even interest-free periods, making them a more affordable way to borrow if you pay off the balance on time.
- Line of credit: A line of credit works similarly to an overdraft. You get a set credit limit, and the money is available when you need it. Unlike an overdraft, a line of credit may offer more flexibility in repayment and potentially lower interest rates.
Before choosing any option, check the terms, interest rates, and fees to find the best fit for your needs.
Final thoughts
Overdrafts can be helpful if you need extra money for a short time. They offer flexibility and quick access to funds, especially in emergencies. However, they also come with risks. Overdrafts can be expensive due to high interest rates, and relying on them too often can lead to financial strain.
Before using an overdraft, consider the costs and whether another borrowing option might be better for you.
FAQs
How does an overdraft work?
An overdraft works by letting you spend more money than you have in your current account, up to a set limit. This is called an overdraft facility. You can use it to cover short-term expenses, but it comes with borrowing costs. Banks charge interest on the amount you overdraw.
Does an overdraft affect my credit score?
Yes, using a bank overdraft can affect your credit rating. Lenders will check your credit history when reviewing applications for loans and they will see how you use your overdraft.
Is an overdraft better than a loan?
It depends on your own circumstances and what you need. Overdrafts are convenient for small amounts and give you quick access to cash. However, relying on them too much can be expensive due to interest rates. Loans are better for borrowing larger amounts, often with lower interest rates, but they require an application process and are less flexible.
Disclaimer: The information given above is provided for reference only. This is not financial advice.