Most of us find ourselves strapped for cash at times, and this is where an overdraft can come in handy. But while there are many benefits to using an overdraft, there are also a number of downsides to consider.
Key takeaways
Overdrafts are a flexible way to borrow.
They can also be an expensive way to borrow, with very high interest rates.
There are a number of advantages to using an overdraft. These include:
Flexible borrowing. An overdraft is there when you need it, so you can dip in and out of it as required.
No fixed repayments. Unlike with a loan, there are no fixed repayments with an overdraft – you simply pay back what you can, when you can.
Quick to apply for. You might be automatically given an overdraft when you open a current account, or if not, it’s quick to apply for one separately.
Easy to ask for an increase. You can ask for your overdraft to be increased (or reduced) at any point.
Interest-free buffer. Some banks or building societies offer an interest-free buffer on their overdrafts, or in a few cases, you might have an interest-free overdraft for a year or more. Many student accounts offer interest-free overdrafts.
What are the disadvantages of an overdraft?
Of course, there are also downsides to using an overdraft. These include:
Lower borrowing limits. You can’t borrow as much with an overdraft as you can with a loan.
Expensive way to borrow. Many overdrafts come with high rates of interest – this can be as much as 40% in some cases, making it a costly way to borrow.
Difficult to get out of debt. Since there is no repayment term, it’s easy to overspend and stay in your overdraft permanently.
Your bank can reduce or cancel your overdraft. An overdraft is a form of credit that can be taken away at any time, even without notice.
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There are 2 types of overdraft – arranged and unarranged. An arranged (or authorised) overdraft is one you’ve agreed with your bank in advance. Some arranged overdrafts might come with an interest-free buffer, meaning you won’t be charged interest if you dip into your overdraft by this amount. However, it tends to only be around £10.
An unarranged (or unauthorised) overdraft, on the other hand, is where you haven’t agreed to an overdraft with your bank but spend more than you have in your account. It can also include going over the limit of your authorised overdraft.
Interest rates and fees on unarranged overdrafts used to be a lot higher than arranged overdrafts. However, new rules introduced in April 2020 mean that banks must now charge a single annual interest rate on all overdrafts, making it easier for customers to compare charges. Interest rates for unarranged overdrafts can no longer be higher than for arranged overdrafts, and rates tend to range from 19% to 40% APR.
Are there any alternatives to an overdraft?
Yes, there are several alternatives to using an overdraft. One is a 0% purchase credit card, which you can use to spread the cost of your spending interest-free over a number of months. Just make sure you clear the balance before the 0% deal ends.
Alternatively, you could use a low APR credit card, which charges a low rate of interest for the life of the debt. This means you can use it for ad hoc purchases, and the interest rate charged will likely be a lot lower than on an overdraft.
You could also consider a money transfer credit card. This lets you move money from your credit card into your bank account. You can then use these funds for purchases or to pay off existing debt. If you choose a card with a 0% introductory offer, you’ll also avoid paying interest for several months. Just watch out for the transfer fee.
Finally, if you need to borrow a lump sum of cash, you could consider applying for a personal loan. Interest rates are generally far more competitive than overdraft rates, but you need to pay back the amount borrowed in fixed monthly repayments over a set term.
Bottom line
Overdrafts can be useful as a backup if you suddenly need extra cash to pay for emergency car repairs or to cover an unexpected bill, for example. However, they should be considered a short-term form of borrowing only, as interest rates on overdrafts can be very high. If you plan to use an overdraft for the long term, it’s better to seek out cheaper alternatives.
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Rachel Wait is a freelance journalist and has been writing about personal finance for more than a decade, covering everything from insurance to mortgages. She has written for a range of personal finance websites and national newspapers, including The Observer, The Mail on Sunday, The Sun and the Evening Standard. Rachel is a keen baker in her spare time.
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