Current accounts are a powerful tool for managing your money. They let you make payments, receive money, and act as the lynchpin for most other financial services you might use in the future.
Beyond simply letting you manage our own money, though, current accounts can also provide an overdraft – a vital line of short-term credit that can really help with your day-to-day cash flow until you’ve sorted everything out.
What are overdrafts?
Overdrafts offer you the ability to borrow from your bank on a revolving basis when your balance dips below zero. In other words, an overdraft lets you keep spending, even when there’s no money left in your account.
Unlike other loans, which are usually standalone products, overdrafts must be linked to a current account – you can’t have an overdraft without a current account. In fact, overdrafts provide banks with one of the main sources of income which enable them to offer free personal banking.
What do overdrafts cost?
Like other types of loans, you are charged whenever you use your overdraft – unless you have a fee-free overdraft, of course, in which case you’ll only be charged if you borrow over a certain threshold. Unlike more traditional loans, not all overdraft charges are based on an interest rate (APR). It has become increasingly common for banks to apply overdraft charges based on a set daily fee.
Daily fees, where you’re charged a fee every day that you’re overdrawn, are easy to understand. However, most overdrafts charged on this basis are more expensive than an interest-based fee structure. To give you some context, interest-based overdrafts usually have a similar APR to a credit card. The effective interest rate on a daily fee overdraft, though, is more like a payday loan – which is one of the most expensive forms of credit out there.
The reason that daily fees tend to cost so much is that they penalise you for borrowing small amounts infrequently. For instance, if you’re charged 50p per day for borrowing any amount up to £500, and you borrowed £20 for 10 days, this would cost you £5 – a £5 charge to borrow £20. If you had borrowed £499 it would’ve cost the same amount.
So, in some sense, you’re encouraged to borrow more. The banks would claim that the fees are high to discourage any borrowing whatsoever, but this is of little comfort if you experience these fees on a monthly basis. If you’re being charged daily fees for your overdraft, you should consider switching to a current account that simply charges interest on overdrafts. If you borrow £20 for 10 days, with an APR of 20%, the total fee would only be 10p.
What overdraft limit will I get?
Just like other revolving credit products (products that don’t have a predefined repayment schedule), your overdraft limit will start off quite low, to reduce the risk of running up an unsustainable level of debt.
Overdraft limits are determined by banks based on a number of factors, including your credit file/score, your income, and how other customers with similar profiles have managed credit in the past.
You might even be refused for an overdraft. If that happens, don’t rush to apply for alternative credit. You might get it, but your current account supplier has a better understanding of your financial position than any other lender. If your bank has concerns regarding your ability to manage and repay an overdraft, you should take notice. Work to improve your credit score and financial management – and then after six months or more, feel free to reapply.
Can I switch bank when I’m in my overdraft?
More often than not, yes. However, it does vary from bank to bank. The most import thing to consider when doing this, if you currently have a high overdraft, is whether your new bank will offer you a similar overdraft limit to your current bank. If they only offer a lower amount, you may be stuck with your existing bank until you can get your overdraft down to a point where you can switch.
Are there alternatives to overdrafts?
There are alternatives to overdrafts, but they tend to be less straightforward. if you know you’re likely to need to use your overdraft over a particular period and you want to minimise your charges, a money transfer credit card might be a better option.
Money transfer credit cards are very similar to balance transfer cards in many respects. However, with a money transfer product you can transfer money directly into your bank account, so you never hit your overdraft.
There are fees associated with these cards (around 4 to 5% of the amount of money transferred), and you need to ensure you pay at least your minimum monthly repayment on time every month – and clear your full balance before your introductory period expires. However, when compared to overdraft fees of 20% APR or daily fees, a 4% one-off charge for borrowing over two to three years is very reasonable.
Image credit: Unsplash