Credit Building > What is an arranged overdraft?

What is an arranged overdraft?

Wollit Team3 minute read · Updated 2nd July 2024

An arranged overdraft is an agreement between you and your bank that allows you to borrow money automatically from the bank when your current account balance reaches zero. This gives you a safety net for covering unexpected expenses.

How does an arranged overdraft work?

With an arranged overdraft, the bank sets a pre-agreed limit on the amount you can borrow. This limit is the maximum amount your account can go into a negative balance. As long as you stay within this limit, they can access the funds as you need them.

Arranged overdrafts are different from unarranged overdrafts, which occur when an account goes over the arranged limit or falls below zero without an agreed-upon overdraft.

An arranged overdraft does not incur charges unless you exceed the overdraft limit.

Also, the bank usually only charges interest on the amount borrowed beyond the interest-free amount offered to you.

How much does an arranged overdraft cost?

The cost of an arranged overdraft can vary depending on the bank and your situation.

Most UK banks charge interest on the amount you borrow, with the usual rate now between 15% and 40% APR.

Here’s an example:

Let’s say you have an arranged overdraft with an APR of 39.9%;
You need to buy something worth £1,200, but your current account only has £200 in it;
If you have an arranged overdraft, you will automatically borrow £1,000 and purchase the item;
If you pay it within ten days, at an interest rate of 39.9% APR, you will pay £9.33 in interest.
If you stay in overdraft for the maximum amount (31 days), the interest charge would be £28.92.

Some banks may also offer a small interest-free “buffer” on arranged overdrafts, allowing you to borrow a certain amount without paying interest or fees. Make sure to check your overdraft’s terms and conditions.

How does an arranged overdraft affect credit score?

Using an arranged overdraft can affect your credit score in ways, both good and bad.

If you stay within the agreed overdraft limit and pay off the balance regularly, it can improve your credit score. This is because it shows to lenders that you are a responsible borrower.

However, if you regularly exceed the agreed-upon overdraft limit or fail to pay off the balance on time, it can hurt your credit score. This suggests you may be struggling financially, which can make you appear more risky to potential lenders.

You might also want to keep in mind that the overall level of unsecured borrowing, including any overdraft debt, is also considered when lenders look at your debt-to-income ratio.

Because of this, an overdraft is not a great credit-building tool. To maintain a healthy credit score, you should aim to keep your overdraft usage to a minimum and pay it off regularly.

What happens if you can’t pay back your overdraft?

If you can pay back your arranged overdraft, you can have serious consequences for your financial situation as well as your credit score:

The bank will report your late or missed payment to the credit reference agencies. This will appear on your credit file and instantly lower your credit score.
If you can’t pay, the bank may close the account. This will again hurt your credit score.
The bank may also sue you, especially if the amount is high. Defaulting and receiving a CCJ also lowers your credit score (by quite a bit, too).

To avoid this situation, contact your bank and let them know if you struggle to repay your overdraft. The bank may be able to offer some form of support or alternative payment arrangements to help you get back on track.

What are the best alternatives to arranged overdrafts?

While an arranged overdraft can be a decent short-term borrowing option, there are other alternatives that you may want to consider.

The first one is a personal loan. Personal loans tend to offer lower interest rates than overdrafts and longer repayment terms.

The second option is a credit card. Credit cards can be a very flexible borrowing option. Some also come with interest-free periods and rewards programs. However, managing credit card usage carefully is important to avoid high interest charges. Cards with long interest-free periods and great rewards are also harder to get, as you’ll need a good credit score to qualify.

The good news is that nowadays, many apps can help you build and improve credit. One of them is Wollit.

Wollit reports a fixed-fee monthly subscription as a loan repayment to all credit reference agencies. This helps you build a history of timely debt repayments, which is the main factor that matters for your credit score.

In time, having a history of better financial habits will improve your credit score, and you’ll find yourself eligible for better and more affordable borrowing options both for emergencies and for your everyday shopping.