Overdrafts Explained

Overdrafts explained

By Laura Rettie, Personal Finance Journalist. Last updated 24th April 2024.

Laura Rettie

An overdraft is a financial arrangement offered by your bank that allows you to withdraw or spend more money from your current account than you have available. 

What is an overdraft?

When you use an overdraft, you’re essentially borrowing money from your bank, which can help you to manage unexpected expenses.

Being ‘overdrawn’ means that you’ve spent more money than you have in your current account

Overdrafts are typically a costly way to borrow money. They should be used only in emergencies or to cover unexpected costs, which you can repay relatively quickly to avoid paying expensive interest fees. 

What are the different types of overdrafts?

There are two different types of overdrafts - ‘authorised’ and ‘unauthorised’. 

Authorised overdrafts

An authorised overdraft, also known as an arranged overdraft, is an arrangement that allows you to withdraw more money from your current account than you have available. An overdraft lets you go into a negative balance, up to a pre-approved limit, without being charged unarranged overdraft fees.

Unauthorised overdrafts

An unauthorised (or unarranged) overdraft happens when you withdraw more money from your current account than you have available without seeking approval from your bank. 

In simple terms, it means spending more money than what’s actually in your current account without an official agreement with your current account provider. 

An unauthorised overdraft can happen when a direct debit takes payment that exceeds the available balance in your account. Your bank may still allow the transaction to go through but will typically charge you a fee for unauthorised borrowing. These fees can be significantly higher than what you’d be charged with an authorised overdraft. 

Banks have different policies regarding unauthorised overdrafts, and some may decline a direct debit or transaction if there are insufficient funds in your account. In contrast, current account providers may allow a transaction or direct debit to go through but will charge you a fee. 

Don’t bury your head in the sand. If you know you haven’t got enough money in your account to cover all your direct debits, contact your bank to discuss the financial difficulties you have to avoid unauthorised overdraft fees.  

What is an overdraft limit?

An overdraft limit is the maximum amount you agree with your bank that you can borrow through your arranged overdraft. Your limit is a cap on how much you can borrow beyond the money in your account. 

For example, you have an agreed overdraft limit of £500 with a balance of £100. If you were to spend £200, you would be overdrawn by £100, and you’d still have £400 left of your overdraft. 

How much does going overdrawn cost?

Authorised overdrafts can sometimes come with a certain amount interest-free, although this is far less common than it used to be. If your current account provider offers an interest-free limit, you can go a specific amount into your arranged overdraft without incurring interest charges.

Using an unarranged overdraft used to be extremely expensive, but in 2020 new rules were introduced that meant authorised and unauthorised overdrafts had to charge the same interest rate, and there could no longer be daily or monthly fees for using an unarranged overdraft. 

These changes caused banks to raise interest rates for arranged and unarranged overdrafts. This did mean that for some, arranged overdrafts became more expensive, but unauthorised overdrafts became far cheaper. The guidance released by the FCA when the new rules were announced was that 7 out of 10 overdraft users would be better off or unaffected by the changes, despite the rise in interest rates.

Interest rates for overdrafts tend to range between 19%-40% EAR variable. 

What is EAR?

EAR stands for Equivalent Annual Rate. It’s a way for current account providers to demonstrate how much interest you’d pay if you remained in your overdraft for a year. 

It’s similar to APR but doesn’t include any fees, though it does take compound interest into account. 

Is having an overdraft a good idea?

When used responsibly, an overdraft can be a helpful tool for managing your finances and bridging the gap between unexpected expenses and your next payday. It can provide temporary assistance when you encounter unforeseen bills or expenses that were not initially accounted for in your budget.

Using an arranged overdraft over a short period can be cheaper than some other forms of short-term borrowing. 

However, if you use your overdraft every month or borrow over a long period, an overdraft could cost you a lot of money, and you may be better off using an alternative, cheaper form of credit.  

If you’re struggling to stay on top of your finances or to repay your overdraft, you should contact your current account provider, who may be able to suggest a strategy to help you. 

Alternatively, you can get free impartial help from Citizens Advice, National Debtline or MoneyHelper. 

Does an overdraft impact my credit score?

A record of you using an arranged or unarranged overdraft will appear on your credit report and be visible to other banks, lenders or companies with access to your credit record. Your credit report will show the following:

  • If you have an overdraft
  • What your overdraft limit is
  • How much of your overdraft you’re using
  • If you’ve used an unauthorised overdraft

Occasionally dipping into an arranged overdraft shouldn’t harm your credit score. Using an arranged overdraft sensibly (staying within your overdraft limit and paying it off regularly) can help to improve your credit score because it demonstrates that you’re a reliable borrower. 

However, regularly going over your overdraft limit or using an unarranged overdraft can negatively affect your credit score and lower your chances of getting approved for credit in the future. Using an unauthorised overdraft gives lenders the impression that you’re in financial difficulty, struggling to manage your finances, or aren’t a responsible borrower.

The information provided does not constitute financial advice, it’s always important to do your own research to ensure a financial product is right for your circumstances. If you’re unsure you should contact an independent financial advisor.