What an overdraft really costs you

What an overdraft really costs you

Overdrafts can be expensive ways to borrow money – and they’re set to get bigger. Here’s how to clear one.

Half of all bank customers use an overdraft when they’re short of cash. Yet many don’t realise that when they use one it’s a form of borrowing. Yep, it’s debt! 

But since people don’t see it as such (some even think of it as free money to spend until the next payday), they don’t treat the debt in the same way they would credit cards, loans and other borrowings.

What is an overdraft?

An overdraft is a way to borrow money from the bank without getting a loan or credit card. These can be authorised and unauthorised. Authorised simply means you’ve agreed one in advance with the bank, often with a set limit. Any use above this or if you don’t have one arranged puts you into an unauthorised overdraft. 

They can be handy for occasionally dipping in to avoid payments and bills bouncing, but it’s easy to drift into it over the months. And the more you use one, the more money it costs.

It’s also one of the big revenue earners for banks. In 2021 they made more than £2.4bn from overdrafts. This money helps fund things like fee-free accounts, switching incentives and interest rates, as well as build up the profits for the bank – all at the expense of those struggling with their finances.

How much can they cost?

The simple answer is potentially a lot of money. The fuller answer is more complicated. That’s because all the banks have different systems. It could be a flat charge for each day you are overdrawn, it could be an interest rate, perhaps a few pence per pound overdrawn, or it could be a mix or some other system. 

This has made it tough to understand what you are actually paying if you use one. And you might not realise that it could easily be costing you as much as 50% APR. That’s a hefty rate of borrowing – much higher than most credit cards. I think that’s something people are likely to be surprised about.

How overdrafts are changing

But this is going to change. The regulator, the FCA, has ruled that the banks must have one simple system for charging for an overdraft. This will mean a single interest rate which you can compare, and no more daily or monthly fixed charges.

Nationwide changed its rate in November 2021 on most of its accounts, moving on a FlexAccount from 18.9% to 39.9% for all customers using an overdraft. That will mean some customers will pay more to borrow via an overdraft – Which? says this will apply to around two-thirds.

HSBC has also announced a similar rise, with a single rate of 39.9% across all accounts from March 2021, though it is adding a £25 interest-free buffer to the “Advance” and standard “Bank” current accounts. Premium customers will get a £500 buffer.

All the other banks have to bring in this simplified rate by 6th April 2021.

Banks also can’t charge more for an unarranged overdraft than an authorised one, essentially meaning there won’t be a difference between the two – though in all likelihood it could mean you can’t use any unarranged overdrafts.

As well as these changes banks will also have to look for persistent expensive debt, try help. It’s not clear yet what this could be, perhaps it’ll see freezing of interest rates on overdrafts for those really struggling, or perhaps offering a cheaper loan to cover the debt.

However, since there’s ages before these rules begin for all banks it’s best to take action now to reduce the cost of your overdraft.

Listen: Cash Chats podcast on the overdraft changes 

I spoke to Sara Williams from Debt Camel in the summer of 2021 about the forthcoming overdraft changes. You can listen here. 

Main image courtesy of Elliott Brown via Flickr

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