However, they can also be expensive, especially if you borrow without arranging the overdraft first, or forget to check the charges your bank or building society imposes for being overdrawn.
In 2020 the way banks charged for overdrafts changed. The changes were imposed on banks by the Financial Conduct Authority and were meant to make borrowing costs more transparent.
There had been a huge variation between products and providers, and charging structures had become more complicated, making it more difficult to shop around and compare prices.
Often borrowers were paying several fees for their overdraft, whether it was an authorised overdraft or not, with a daily interest charge and a fixed monthly fee.
As a result of the changes overdrafts rates rose to an all-time high.
At the same time at least 27 million bank accounts lost access to an interest-free overdraft buffers of up to £500, according to the financial trade body UK Finance.
Banks now charge between 35% and 39.9% on overdrafts, and monthly fees have largely been removed.
|Bank account||Previous overdraft rate||New rate|
|First Direct First||19.9%||39.9%|
|Barclays Bank Account||19.51%*||35%|
Data supplied by Moneyfacts. Last updated December 2020
* Capped at £90 a month | ** 27.5% for Club Lloyds customers
The increase in overdraft rates mean it may now be cheaper to borrow using a credit card – if you are able to pay the money back within a short period of time.
However, if you only occasionally dip into your overdraft, using it may still be a cheaper way to borrow as the rise in overdraft charges largely only affects those who are regularly overdrawn.
The changes should make it easier to compare overdraft charges and banks say daily fees are easier to understand but you may be better off trying to avoid using the overdraft facility altogether.
Andrew Hagger, founder of personal finance site MoneyComms said the changes had been meant to help people compare overdraft rates.
“But what the regulator and customers didn’t expect was for most banks to replace lost revenue from soon-to-be banned unauthorised charging, by simply increasing agreed overdraft rates to almost 40% EAR (Effective Annual Rate) in many cases.
“Yes, the new regulation will make it easier to compare overdraft costs between banks, and the problems around unarranged overdraft fees will be eradicated, but rather than review their cost models the banks have taken the easy option and simply shifted the cost of banking.”
If you find that you often need to use your overdraft then it may be worth finding a bank account with lower overdraft charges or a slightly higher interest-free buffer, although at the moment the average buffer is just £25.
Some current accounts charge a monthly fee in exchange for having access to a free overdraft. But you will need to have a good credit record to access this.
You can compare rates by looking at the EAR or the Equivalent Annual Rate, which looks at the interest you would be charged if you were to remain overdrawn for an entire year.
The EAR also calculates compound interest. The Annual Percentage Rate (APR) has to take into account other account fees and is designed to allow customers to compare overdraft costs.
One option you might consider, if you know it is going to take a while to pay off the debt, is to move your outstanding debt onto a card.
Before you switch check whether there is a transfer fee and whether you will save money once you have factored that in.
It might make sense to get a card with a shorter 0% period but with lower (or no) fees. As with all forms of credit, make sure you have a plan for paying off the card before the 0% interest period ends.
It’s common to dip into the red if a regular direct debit is taken from your account before a cheque or cash transfer is cleared. To avoid this, you can anticipate when you might step into overdraft territory by using an app to predict your cash flow and bank balance.
The introduction of open banking means there are apps you can use that can look at what you are spending and help you work out where you can save money.
An example is Money Dashboard. If you have an account with Bank of Scotland, Barclaycard, Barclays, First Direct, Halifax, HSBC, Lloyds, MBNA, Nationwide, NatWest, RBS and Santander you can sign up to use the app.
If you have premier banking, you can access a free overdraft facility, but you will have to pay a fee.
Andrew Hagger argues that banks need to be more honest about how much they charge current account customers and that there is no such thing as free banking.
The best thing to do is to make sure you use your overdraft wisely and try and make use of some of the challenger banking technology to save money elsewhere.
“It’s early days for open banking but in time it should help people to compare products and services,” says Andrew Hagger. “It is difficult to work out the best deals at the moment and the banks know that is why people stick with the same account, even when charges are relatively high.”