How Overdrafts Work
An overdraft can be an arranged or unarranged loan you take through your current account when you’re out of money. An annual interest rate will apply when you borrow
When you open a current account you may be given an overdraft, which allows you to borrow from your bank if your balance drops to zero.
All banks and building societies charge an annual interest rate on their overdrafts.
Through October 2020, all banks had been told to offer customers the first £500 of their overdraft interest-free, if they were struggling financially because of the COVID-19 pandemic. At the moment, new rules require firms to offer tailored options for anyone who is struggling with overdraft costs. If you need assistance, contact your bank or building society.
If you are considering a new overdraft, here we explain what an overdraft is, how overdrafts work, the penalties for using them, and how much they’ll cost you.
How to use an overdraft
If you have an overdraft, you can borrow money from your bank through your current account. Using an overdraft can help if you need to make a payment, for a household bill for example, but don’t have enough money in your current account. However, they can be expensive and are best used for short-term borrowing.
Your bank may automatically give you an overdraft, or you can apply for one. The bank will check your credit history before it allows you to have one, and it will use this information to decide the size of the overdraft.
How much will an overdraft cost me?
The amount you pay depends on your bank. Under the new rules introduced in 2020, banks have to charge a single interest rate on all the money in an overdraft - whether it’s arranged or unarranged (or authorised and unauthorised).
Annual interest rates vary depending on the bank or building society but can be as high as 40%.
What’s the difference between arranged overdraft and unarranged overdraft?
An arranged overdraft is the amount of money you can use in your overdraft which you have agreed in advance with your bank or building society.
An unarranged overdraft is a small amount of money you can borrow if you have spent all the money in your account or arranged overdraft.
The interest rate applies to both types of borrowing, but you may still be able to have a small, interest-free overdraft.
How to manage your overdraft
If you’re paying a high price for your overdraft, and you’re dipping into it regularly, it might be worth switching to a different current account with a cheaper overdraft rate.
You should also aim to pay off the overdraft as quickly as you can when you borrow against it.
Alternatively you could consider another way to borrow, such as a credit card or personal loan if the interest rate is lower.
» MORE: Do I need a credit card?
Switch to a cheaper overdraft but be aware of your limits
By switching your current account you could cut your costs. You’re allowed to switch current accounts if you’re in your overdraft but the bank you’re switching to will need to accept this and won't always automatically allow it.
» COMPARE: Overdraft current accounts
Some banks and building societies offer interest-free overdrafts on their current accounts. This is often attached to an account to persuade people to switch. However, it’s important to find out when the 0% period ends. At this point you’ll need to pay interest on the overdraft if it’s not already cleared.
Rebecca Goodman is a freelance journalist who has spent the past 10 years working across personal finance publications. Regularly writing for The Guardian, The Sun, The Telegraph, and The Independent. Read more