In simple terms, an overdraft is when your bank allows you to borrow money through your current account, which is more than you have in your actual bank account. This is called being overdrawn. Think of it like a loan from the bank.
To arrange an overdraft the bank usually charges a fee. From 9 July 2020, most banks will start charging an interest rate of up to 40%.
To learn more about how to arrange an overdraft, and what you should consider if you have one, read our guide.
If you have an overdraft, this means that your bank is allowing you to borrow extra money through your current account.
So let's say you have no money in your current account, and you spend £50, this would make your current balance minus £50, and you have used your overdraft to make this payment.
Using your overdraft is like using money that the bank is loaning you, as it will be repayable. The type of current account you have with your bank, will determine how much interest you will be charged over a period of time. Such as 7 days, 30 days or 60 days, each bank will have their own charges, which they will make you aware of.
There are two kinds of overdraft, and the difference between them is key:
Authorised overdraft With an authorised overdraft, you have a set overdraft limit, which you pre-arrange with your bank. You are likely to have to pay interest, or a fee in return for making use of the overdraft facility. The amount you will be offered as an overdraft will vary from person to person, and is usually determined by your personal finances.
Unauthorised overdraft This is where you haven't agreed an overdraft facility with your bank in advance and have withdrawn more money than you have in your bank account, or you have taken out more than your authorised overdraft limit.
Unauthorised overdrafts are to be avoided, because they are often subject to charges and fees, which can be very expensive.
Overdrafts can be a good way to borrow small amounts of money, for a short period of time. But most overdrafts are not a very effective way of borrowing in the long-term, because they may come with a higher rate of interest than some loans and even some credit cards.
Even if your current account is always in credit, it can be a good idea to have an overdraft facility arranged with your bank.
Having an overdraft can act as a useful buffer to protect you from fees, and charges for unauthorised borrowing if you ever accidentally overspend, or find yourself needing a little extra money.
Accounts with 0% interest fee are ideal for this kind of situation. These are also a good idea if you're trying to pay off your current overdraft. This will give you time to clear your current debt. However, it's important to remember they only last for a period of time, such as one year, after this time the interest rate can be quite high.
If you're frequently overdrawn, or often go overdrawn without authorisation then you should really check to see if you're getting the best deal on your current account, as you could be paying far more than you need to in interest or charges.
If you have a big overdraft and you can't or don't want to switch to a 0% overdraft account, you could look at switching your overdraft to a cheaper type of borrowing.
You could look at getting a personal loan at a lower rate of interest than you are paying on your overdraft.
There are a few things you can introduce to your daily routines, which can help you keep control of your spending, and ultimately manage your overdraft.
Check your account regularly - keeping track of your spending can help you stay on top of your finances, and pay attention to how close you are to your overdraft, or using an unarranged overdraft.
Download your bank's app - having easy access to your finances will make it easier to see what's going on with your money. You can also set up notifications or alerts, to let you know when you're close to being overdrawn
Read all of the letters/emails from your bank - when dealing with debt, it can be easy to bury your head in the sand. It's important to not only know what's going on with your account, but to keep track of bank changes/charges.
Consider using your savings - if you have access to savings, it might be worth using your savings instead of accessing an overdraft. This will save you having to pay overdraft fees, arranged or unarranged. Savings are also worth considering to clear your overdraft if the fees per day are high.