Overdrafts How They Work, Costs and What to Know
Understand overdrafts, arranged and unarranged borrowing, overdraft limits, interest and fees, eligibility, potential benefits and risks, and how to use an overdraft responsibly when managing your money.
What is an overdraft?
An overdraft is a form of short-term borrowing linked to a bank account. It can allow you to spend more money than is currently available in your account, up to an agreed limit where an arranged overdraft is provided.
An overdraft can be useful for managing a temporary gap between money going out and money coming into your account. However, borrowing through an overdraft can cost money, and the cost can increase if the borrowing remains outstanding.
An overdraft is different from money you already have in your account. When you use an overdraft, you are effectively borrowing from your bank or account provider under the terms of the account.
How does an overdraft work?
If your account has an arranged overdraft, your provider may allow your balance to fall below zero up to the agreed limit. The provider may charge interest or other applicable costs depending on the account terms.
The exact overdraft limit, interest rate, fees and eligibility requirements vary between providers and accounts, so it is important to check the current terms before using one.
Three overdraft terms worth understanding
Overdraft terminology can look complicated at first. These three concepts provide a useful starting point.
Overdraft limit
The maximum amount of arranged overdraft borrowing your provider has agreed to make available under the account terms.
Overdraft interest
The borrowing cost that may apply when you use an overdraft. The rate and charging method depend on the provider and account.
Available balance
The amount available to spend can take account of your account balance, pending transactions and any available overdraft facility.
Arranged vs unarranged overdrafts
The distinction matters because the terms, availability and consequences can differ when you borrow beyond your normal account balance.
Arranged overdraft
An arranged overdraft is agreed with your bank or account provider in advance. You are given an overdraft limit that can be used according to the account's terms.
Unarranged overdraft
This generally refers to spending beyond an arranged overdraft limit or entering an overdraft without an agreed facility. The treatment depends on the provider and circumstances.
Your account terms
How much does an overdraft cost?
The cost of an overdraft depends on the account provider, the overdraft arrangement and how much you borrow. Interest is a key cost to understand, but the exact charging structure can vary.
An overdraft can become expensive if it is used frequently or remains outstanding for a long period. This is why an overdraft is generally better understood as short-term borrowing rather than a permanent source of funds.
What affects the cost?
- The amount borrowed.
- The applicable overdraft interest rate.
- How long the balance remains overdrawn.
- Any applicable account or transaction charges.
- The specific terms and conditions of the account.
Before using an overdraft, check the provider's latest pricing information so you know how borrowing is charged.
Benefits and risks of using an overdraft
An overdraft can provide flexibility, but it is still borrowing. Understanding both sides can help you make a more informed decision.
Potential benefits
An overdraft can be useful in certain short-term situations when used within an agreed limit and managed carefully.
Potential risks
Regular or prolonged overdraft use can make it harder to regain a positive account balance and may increase borrowing costs.
Who can get an overdraft?
Overdraft eligibility is determined by the bank or account provider. Having a current account does not necessarily mean that an overdraft will automatically be available.
Providers may consider information about your financial circumstances and account history when assessing whether an overdraft facility is appropriate and what limit may be offered.
How to use an overdraft responsibly
An overdraft can be useful for short-term cash-flow gaps, but managing the borrowing deliberately can help prevent it becoming a regular financial dependency.
Know your limit
Understand the arranged overdraft limit and avoid assuming that the full amount is money you own.
Track your balance
Monitor your account regularly so you know when you are using borrowed money and how much remains outstanding.
Understand the cost
Check the current overdraft interest rate and any other relevant charges before relying on the facility.
Have a repayment plan
If you use an overdraft, consider how and when your account will return to a positive balance.
Is an overdraft right for you?
An overdraft may be useful when you need short-term flexibility, but it should be considered alongside the cost of borrowing and your ability to bring the account back into a positive balance.
Consider why you need the overdraft
If you need an overdraft because of a one-off timing issue, it may serve a different purpose from an overdraft that is being used every month to cover regular living costs.
Look at the full cost
Compare the applicable interest rate, charges and account terms. A lower overdraft limit does not necessarily mean lower borrowing costs if the facility is used frequently.
Review your monthly cash flow
Looking at regular income and essential spending can help you identify whether an overdraft is solving a temporary timing issue or a recurring budget shortfall.
Consider alternatives where appropriate
Depending on your circumstances, other financial products or budgeting approaches may be more suitable. Compare the costs and terms rather than choosing a product solely because it is convenient.
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Questions about overdrafts
Overdraft rates, limits, eligibility and charging arrangements can vary between providers. Always check the latest account information before using an overdraft.
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