How does an overdraft work?
No matter how great you are at budgeting, we all need a little wiggle room now and then, and may need to dip into an overdraft. But, how does an overdraft actually work?
An overdraft essentially allows you to take money from your current account that you don’t actually have. It's a loan from the bank that allows you to be 'overdrawn' - so when your existing money hits zero, you can still spend.
But it can be an expensive way to get hold of extra cash - you could be stung with a whopping interest charge of as much as 40% of every bit of extra cash you use. Almost all overdrafts come with a charge of some kind.
It used to be that high interest rates were only charged to those who went into an un-arranged overdraft (e.g. those who did not have an agreement with the bank before going overdrawn), but new rules from the Financial Conduct Authority mean everyone is charged the same rate.
Banks may have provided some temporary respite last year because of coronavirus, but most banks now have this charge structure in place. If you often rely on an overdraft buffer, then here’s everything you need to know about overdrafts and how to avoid high charges.
How to avoid high overdraft charges
Change your bank
For whatever reason, human nature makes us loyal to our banks and afraid of switching up our accounts. But if you are regularly relying on an overdraft, switching accounts could be worthwhile.
Whilst a 40% in interest for your overdraft is the new norm, there are some that allow you to go into overdraft for free, up to a certain amount.
Here are the banks that have an interest free overdraft buffer:
First Direct 1st Account - £250 interest free overdraft
M&S Bank current account - £250 interest free overdraft
Worried about the stress of switching? No need. It’s now super easy with the Current Account Switch Service - which means the banks have to do all the legwork and a switch must be completed within seven working days.
Ask for help
If your income is severely impacted by the pandemic, you should talk to your bank to see if they can help you. Many will provide help on a case by case basis.
If you bank with Lloyds Banking Group (which includes Lloyds, Halifax and Bank of Scotland) you may still be able to apply for an interest-free overdraft extension. You have until 31 January 2021 to apply.
If you’re a Santander customer, you have until 4 May 2021 to ask for a £500 interest free overdraft buffer and a reduced interest rate of 19.9%.
Before you opt for overdrafts, make sure you absolutely need it - as it is a debt and you need to pay it back eventually.
Cheaper overdrafts
If you have a good credit score and need to go into an overdraft above your free buffer, then check out the app-based banks like Starling or Monzo, where overdrafts interest rates are at a lower 15% and 19%.
Pay off your overdraft
If you're already using an overdraft, but have savings - then use these savings to pay it off.
Your overdraft is costing you more than what your savings are earning you when you compare the interest you're paying on your overdraft compared to the interest you're making on your savings. It’s a no brainer. Although, we understand coronavirus may have impacted your income, so make sure you have enough savings to cover your living costs and bills first.
Get help with debt
If you really are struggling with bills and feel like your debt is unmanageable then don’t be afraid to get help. Speak to a debt charity like StepChange - they can help you come up with a repayment plan and even negotiate with your bank and other creditors. Nothing is as ever as bad it may seem, and talking about it will put your mind at ease.
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