Credit Score Basics > How do overdrafts work?

How do overdrafts work?

An overdraft is a way of borrowing money through your bank account. It lets you spend more money than you have in your account.

You can think of it as having a negative balance. This usually happens when you make a more expensive purchase than you can afford. In other words, once your current account balance goes below £0, you're "overdrawn".

In the UK, there are two types of overdrafts: arranged and unarranged.

How do arranged overdrafts work?

An arranged overdraft ("authorised") is a pre-agreed amount of money your bank allows you to spend beyond your account balance. It can be a helpful safety net for things like unexpected bills. However, you will be charged interest for every day you use your arranged overdraft beyond any interest-free limit you have agreed upon with your bank.

How do unarranged overdrafts work?

An unarranged overdraft occurs when you spend more money than you have in your account without an agreed-upon limit. This can hurt your credit score since potential lenders consider it a red flag. You're basically going over the limit of an authorised overdraft and breaking your agreement—not a good look.

How do overdraft fees work?

Banks and building societies' interest rates on overdrafts range from 19% to 40%. This makes them more expensive than personal loans and credit cards and almost as expensive as credit-building credit cards.

Also, until April 2020, banks were allowed to charge higher fees for unauthorised overdrafts. They're not allowed to do this anymore.

Instead, interest on both kinds of overdrafts is now calculated using a single annual interest rate (APR). This makes it easier to compare charges between banks.

What are the pros and cons of overdrafts?

Overdrafts can be a practical short-term borrowing solution. Still, they should be used responsibly and managed carefully to avoid high charges and potential damage to your credit score.

Here are some of their pros:

• Flexible borrowing: Compared to a personal loan, overdrafts allow you to borrow only what you need at the time.
• Quick and convenient: using overdrafts is fast and without any fuss.
• No hard credit check: most banks will not run a hard credit check when you open an account with an overdraft option. Too many hard credit checks can quickly hurt your credit score.

Overdrafts also have cons, though:

• Lower borrowing limits: the amount you can borrow through an overdraft is usually tiny.
• Expensive way to borrow: Overdrafts often come with high-interest rates.
• Not guaranteed: the bank might withdraw your overdraft option at any time.

The main point is that an overdraft should be for short-term borrowing or emergencies only, not a long-term borrowing solution or a tool to build credit history.

In fact, a study by the Financial Conduct Authority (FCA) found that most people don't realise just how often they use their overdrafts. If you're using your overdraft more often than you planned, you might be better off borrowing through a personal loan or getting a credit card.

And you'd certainly be better off building credit through a specialised tool.

One such tool is Wollit. Wollit reports your monthly fixed fee subscription as a loan repayment, helping you build your credit history without the risks and high charges of an overdraft.

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