Overdrafts
What are they?
Overdrafts are effectively temporary loans that kick in should the balance on your bank account fall below zero. There's usually a limit of between £100 - £500 and rates
of interest can be high, as can additional fees (especially if you haven't agreed the overdraft with your bank beforehand).
Types
There are two types of overdraft:
AuthorisedUnauthorised
This is when your overdraft is within a limit pre-agreed by your bank, e.g. £250. Banks do not normally charge you any fees for using this overdraft, but might charge
annual interest of up to 20% or more.
If you exceed the pre-agreed limit you'll enter the unauthorised overdraft zone, which is where costs can mount up.
Your bank will probably charge you an unauthorised overdraft fee of around £20 but, even worse, they'll usually charge you a similar amount each time (or day) you make
a transaction that pushes you further into the overdraft. It's easy to run up charges of £100 or more if you're not careful.
This practice has attracted a lot of controversy, to the point the Office of Fair Trading (OFT) took several banks to the High Court in a test case claiming these
charges are unlawful - but surprisingly the OFT lost.
You'll also have to pay interest, usually at a high rate of between 20% - 30%. While this won't amount to much over a day or two, it can really add up over time.
Mr Lucky has a £250 authorised overdraft limit at a rate of 18%. He is overdrawn by £200 for 30 days, his only charge is interest of just under £3.
Mr Hammered has the same authorised limit but becomes overdrawn by £300 for 30 days. His unauthorised rate is 30% and his bank charges £20 for breaching the authorised limit and a
further £20 for each of three small transactions that added to the overdraft. His total charges and interest amount to around £87!
Features
Some, but not all, banks may offer one or more of the following overdraft features.
BufferGrace Period
If you have a 'buffer' you can slip into an agreed amount above your authorised overdraft without the usual penalties applying. However, you may still have to pay
interest and a buffer fee. Buffers vary between banks, but typically range from £10 to over £100.
On the day you slip beyond your authorised overdraft your bank gives you until their close of business that day to rectify the situation.
Understanding the rate
Overdraft intrest is quoted as an Effective Annual Rate (EAR). This takes into account the interest you could end up payingon interest, i.e. compounding.
For example, if annual overdraft interest is charged at 20% a year but calculated daily, the EAR would be 22.1%.
Should I use one?
Provided you stick to your authorised overdraft for short periods of time, then an overdraft can be an excellent way to cope with the odd financial hiccup. However,
straying into the realms of unauthorised overdrafts can be very costly.
If possible, it's far preferable to instead use a credit card with a 0% or low introductory rate to tide you through such times.
If you think you'll be overdrawn beyond your authorised limit for more than a month then consider a flexible bank loan instead, as it could end up being cheaper. However,
bear in mind that many banks have a £1,000 minimum loan amount and you'll need to be able to afford the repayments.
Jargon
Here's some of the more common overdraft jargon you might come across:
| Authorised Overdraft | When your bank account has a negative balance, with the bank's permission. Terms are usually favourable compared to an unauthorised overdraft. |
| Buffer | An agreed amount above your authorised overdraft into which you can slip without the usual penalties applying. |
| Overdraft | A temporary loan that kicks in should the balance on your bank account fall below zero. |
| Unauthorised Overdraft | When your bank account has a negative balance, without the bank's permission. This can result in stiff charges and high interest. |