What is an overdraft Explained

Ashly Chole Senior Finance Researcher

Last Updated 10 April 2024

Understanding Overdraft: How It Works, fees, and More

An overdraft can be a useful tool to manage your finances, but it's important to use it responsibly and understand its associated fees. Before using an overdraft, consider your other options and shop around to find the best terms and fees for your needs. If you're unsure whether an overdraft is right for you, it's always a good idea to speak to a financial advisor or a representative from your bank.

What is an overdraft, and how does it work?

An overdraft is a credit facility offered by banks and other financial institutions that allows account holders to withdraw more money than they have. It is a form of short-term borrowing that can be useful in case of unexpected expenses or cash flow problems.

When you use your overdraft, the bank will charge you interest on the borrowed amount. The interest rate can vary depending on the bank and the type of account you have.

How can I use an overdraft to manage my finances?

An overdraft can be useful for managing your finances, especially when unexpected expenses arise. You can use it to cover bills or other expenses until your next paycheck arrives. However, it's important to use your overdraft responsibly and not rely on it as a long-term solution to your financial problems.

What are the fees associated with overdrafts?

The fees associated with overdrafts can vary depending on the bank and your account type. Some common fees include:

  • Arranged overdraft fee
  • Unarranged overdraft fee
  • Interest charges

Is an overdraft a form of credit or a loan?

An overdraft is a form of credit but not a loan. It's a revolving line of credit that you can use as needed, up to a certain limit.

Can anyone get an overdraft, or is it only available to certain customers?

Not everyone is eligible for an overdraft. Banks typically require you to have a good credit score and a steady income before they will offer you an overdraft facility. The availability and terms of an overdraft can also depend on the type of account you have.

How do I apply for an overdraft, and what do I need to qualify?

To apply for an overdraft, you must contact your bank and fill out an application form. The bank will typically check your credit score and income to determine your eligibility for an overdraft facility.

What are the advantages and disadvantages of using an overdraft?

An overdraft is a financial arrangement that allows a bank account holder to withdraw more money than they have available in their account, up to a predetermined limit. The advantages of an overdraft include:

  • Flexibility: An overdraft provides flexibility to account holders in terms of managing their finances. It allows them to make purchases or pay bills even when they don't have sufficient funds in their account.
  • Convenience: Overdrafts are readily available to most account holders and can be accessed quickly and easily through online banking or an ATM.
  • Cost-effective: Compared to other forms of credit, such as credit cards, personal loans or payday loans, overdrafts are usually less expensive and can be a cost-effective way to borrow money in the short term.
  • Interest only on the amount borrowed: An overdraft allows account holders to pay interest only on the amount borrowed and for the period it is borrowed. Interest only makes it a more affordable option than other credit facilities where interest accrues from the date of borrowing.
  • Improves credit score: If an overdraft is used responsibly and repaid on time, it can help improve an account holder's credit score. A good credit score can make it easier to access other types of credit in the future.

However, it's important to note that overdrafts should be used responsibly and only as a short-term solution. They can become expensive if not repaid quickly and lead to a debt cycle. It's important to regularly monitor your account to ensure you stay within your overdraft limit and repay the borrowed amount as soon as possible.

While overdrafts have their advantages, they also have some disadvantages that you should consider:

  • Fees: Banks typically charge fees for using an overdraft, such as an overdraft fee, an annual fee, or a daily fee. These fees can add up quickly and make the overdraft more expensive than other forms of credit.
  • Interest rates: The interest rates on overdrafts can be high, making it expensive to borrow money in the long run. Over time, the interest charged on an overdraft can significantly increase the amount owed.
  • Repayment terms: Overdrafts are designed to be short-term solutions, but they can become long-term debts if not repaid quickly. Some banks may require you to repay the overdraft in full after a certain period, or they may require you to make minimum payments each month.
  • Impact on credit score: If you rely too heavily on overdrafts or fail to repay them on time, it can negatively impact your credit score. Bad credit scores can make it harder to access other types of credit in the future.
  • Overdraft limit: The bank predetermined your overdraft limit, and it may not be enough to cover your expenses. You may face additional fees and penalties if you exceed your overdraft limit.

It's important to weigh an overdraft's advantages and disadvantages and use it responsibly. An overdraft can be useful in managing your finances, but it should only be used for short-term borrowing needs and repaid as quickly as possible to avoid high fees and interest charges.

How much can I borrow with an overdraft, and for how long?

The amount you can borrow with an overdraft and the length of time you can borrow it for can vary depending on the bank and your account type. Banks may also set different limits for arranged and unarranged overdrafts.

Can an overdraft affect my credit score?

Yes, an overdraft can affect your credit score. If you use your overdraft frequently or exceed your limit, it can negatively impact your credit score. On the other hand, using your overdraft responsibly and paying it off on time can help improve your credit score.

What happens if I exceed my overdraft limit?

If you exceed your overdraft limit, you may be charged an unarranged overdraft fee, which can be expensive. Your bank may also charge you additional fees and interest on the amount you've borrowed. It's important to stay within your overdraft limit to avoid these fees.

Can I cancel an overdraft agreement?

You can cancel an overdraft agreement anytime by contacting your bank. However, you will still be responsible for paying off any outstanding balance on your overdraft.

How does an overdraft differ from a line of credit or personal loan?

An overdraft is a revolving line of credit attached to your bank account. You can use it as needed, up to a certain limit. A line of credit is a similar type of credit facility, but it is not attached to a specific bank account. On the other hand, a personal loan is a lump sum of money you borrow and pay back in instalments over a set period.

Do all banks offer overdraft facilities?

Not all banks offer overdraft facilities, but most do. The availability and terms of an overdraft can vary depending on the bank and the type of account you have.

How do I know if I have an overdraft, and how do I check my balance?

You can check if you have an overdraft by looking at your bank account statement or logging into your online banking account. Your balance will show your available funds, including any overdraft facility you have. You can also contact your bank for more information about your overdraft balance and limit.

Are there any alternatives to using an overdraft?

Yes, there are several alternatives to using an overdraft, including:

  • Credit cards
  • Personal loans
  • Payday loans
  • Short-term installment loans

It's important to consider the fees and interest rates associated with each of these options before deciding which one to use.

Can I negotiate the terms of my overdraft agreement with my bank?

Yes, you can negotiate the terms of your overdraft agreement with your bank. Including negotiating a lower interest rate or a higher overdraft limit. However, the bank is not obligated to agree to your terms.

What are the consequences of defaulting on an overdraft?

If you default on an overdraft, you may be charged additional fees and interest. Your bank may also report your account to credit bureaus, which can negatively impact your credit score. In extreme cases, the bank may take legal action to recover the money you owe.

How can I avoid paying excessive fees on my overdraft?

To avoid paying excessive fees on your overdraft, it's important to stay within your limit and to pay off your overdraft balance as soon as possible. You should also shop for the bank that offers the best overdraft terms and fees for your needs.

How does the interest rate on an overdraft compare to other forms of credit?

The interest rate on an overdraft can vary depending on the bank and your account type. In general, the interest rate on an overdraft may be lower than the interest rate on a credit card or a payday loan, but it may be higher than the interest rate on a personal loan.

Are there any tax implications associated with using an overdraft?

There are generally no tax implications associated with using an overdraft, as the interest you pay is not tax-deductible. However, if you use your overdraft to invest in a business or other income-producing activity, you may be able to deduct the interest on your tax return.