How does an overdraft work and what does it really cost?
Arranged and unarranged overdrafts, why they are quoted as an APR now, and the reason a small permanent overdraft can cost more than a loan.
- Difficulty
- beginner
- Time
- 30 min
- Read
- 4 min
- Safety
- caution
Short answer
An overdraft is a short-term credit facility on your current account, charged as an interest rate rather than daily fees. An arranged overdraft is agreed in advance; an unarranged one is not and is usually more expensive and more damaging to your credit file. If you are always in it, it is not a buffer — it is a debt with a very high rate.
The rules changed so that overdrafts are priced as a single interest rate rather than as daily and monthly fees, which made the true cost visible for the first time. What it revealed is that overdraft rates are typically far higher than personal loan rates. That is fine for a few days a month and expensive as a permanent state.
Safety
Step by step
- Find out whether yours is arranged.An arranged overdraft is a limit agreed with the bank. Going beyond it, or overdrawing with no arrangement, is unarranged and is treated differently.
- Find the actual rate.It is quoted as an annual rate in your account terms and in the app. Compare it with a personal loan rate and with a credit card rate to see where it sits.
- Work out what you actually pay.Interest accrues on the amount overdrawn for the days you are overdrawn. Ten days a month at a modest balance costs much less than the headline rate suggests; being permanently overdrawn does not.
- Check whether an interest-free buffer applies.Some accounts include a small interest-free amount. It changes the arithmetic for people who dip in and out by small sums.
- Distinguish a buffer from a debt.If the balance returns to positive every month, it is a buffer. If the account never gets back to zero, the overdraft is a debt that happens to be attached to your current account.
- Compare the cost against alternatives.For a persistent balance, a personal loan or a credit union loan is usually cheaper, and it has an end date, which an overdraft never does.
- Think about timing before borrowing.Moving direct debit dates to just after payday removes the need for a lot of short-term overdraft use entirely.
- Know the effect on your credit file.An overdraft is reported as credit. Being consistently at the limit affects how lenders see you, and unarranged borrowing is viewed worse than arranged.
- Ask the bank for help if it never clears.Banks are expected to identify and contact customers in persistent overdraft use and to offer support. You can ask before they do.
- Reduce the limit deliberately once you are out.A limit you cannot reach is a limit you cannot slide back into.
Tips
- Compare the overdraft rate with a personal loan rate. For a balance you never clear, the loan is usually far cheaper and has an end date.
- Ask your bank to move direct debit dates rather than borrowing to cover them. Most will, and it is free.
- Reducing the overdraft limit in steps as you pay it down stops the balance drifting back up.
Common mistakes
- Treating a permanent overdraft as normal — It is high-cost borrowing with no repayment schedule, so it never reduces on its own and it is one of the most expensive ways to hold a balance.
- Relying on unarranged borrowing — It costs more, it can trigger returned payment problems with the companies you owe, and it looks worse on your credit file than an arranged facility.
If it doesn't work
You are overdrawn every month before payday
Cause: Payment dates are stacked before income arrives — Fix: Ask companies to move direct debit dates to a few days after payday. It removes the need for most short-term borrowing.
The balance never returns to zero
Cause: The overdraft has become a debt rather than a buffer — Fix: Treat it as a debt with a repayment plan, or move it to a cheaper form of borrowing with a fixed end date. Free advice is available if that is not possible.
The limit was reduced or withdrawn without warning
Cause: The bank reassessed the facility, which it is generally entitled to do — Fix: Ask for the reason and for time to arrange alternatives. Complain if the notice given was unreasonable.
Questions people ask
Is an overdraft worse than a credit card?
Overdraft rates are often higher than credit card purchase rates, but the comparison depends on how long you hold the balance and whether an interest-free period applies. Compare the annual rates directly.
Does having an overdraft hurt my credit score?
Having one is not inherently negative. Being consistently near the limit, and unarranged borrowing in particular, is what lenders read badly.
Can the bank take the overdraft away?
Generally yes, subject to the account terms and reasonable notice. That is one reason not to build a household budget around one.