What is an overdraft and how does it work?

Financial institutions often offer accounts with overdraft services. An overdraft is a certain amount of money that individuals can temporarily owe to the institution if their accounts aren't able to cover a transaction.¹

Understanding overdrafts

The definition of an overdraft is a financial institution’s extension of credit to an account holder if there are insufficient funds to complete a transaction. It means that the bank lets an individual take out more money than is in the account. In other words, if someone goes into an overdraft, they are getting into debt.²

When an account is overdrawn, this is borrowing, which in turn triggers interest charges.

Types of overdrafts

When it comes to short-term borrowing in the form of overdrafts, there are typically two main categories:³

• Arranged overdrafts. These are sometimes referred to as authorised overdrafts.
• Unarranged overdrafts. These are sometimes referred to as unplanned or unauthorised overdrafts.

Each has a different set of financial implications, as explained below.

Arranged overdrafts

When an overdraft is arranged, or authorised, there is an agreement between the bank and an account holder that a certain amount of money can be spent if the account has insufficient funds.

An arranged overdraft can provide more financial flexibility in certain situations. It can help manage temporary cash flow issues by avoiding higher fees if a transaction or cheque would have been declined due to insufficient funds, for example.³

Unarranged overdrafts

If there is no agreement between the financial institution and the account holder, and more money is spent than was in the bank account, then that person accessed an unarranged, or unauthorised, overdraft. This can also happen if a person went over an agreed-upon limit.

Interest fees for unarranged overdrafts used to be higher than for arranged ones. But since April 2020, banks have been forbidden to impose higher charges for unarranged overdrafts. Still, fees often vary from 19% to 40%, or higher.³

Unarranged overdrafts may be avoided by regularly checking account balances and by setting up an alert for low account balances. Another possibility is to ask the financial institution for an arranged overdraft for more flexibility.

How does an overdraft work?

Overdraft services are a form of short-term borrowing that is associated with an individual’s bank account, usually their current account. And it is intended to be temporary.

Some financial institutions reach out to account holders to offer current account overdrafts, but individuals can also contact their bank to inquire about them. During the overdraft application process, it’s important to understand overdraft basics.

Example of an overdraft transaction

Overdrafts can provide a temporary safety net to allow transactions to go through even if an account has insufficient funds. For example, if an account balance is 250 GBP, and the account owner needs to pay a higher-than-expected utility bill of 300 GBP with a debit card, the overdraft will allow the transaction to complete, even if the account will be in a -50 GBP balance.

Having an overdraft for emergencies such as these can help provide peace of mind. But having an awareness of the overdraft limit is important to avoid going over it.

How do overdraft charges work?

Having access to overdraft facilities can help prevent potentially uncomfortable moments, such as a card decline. But overdrafts are subject to interest although some banks may allow a small interest free amount.

In general, it’s best to pay back the overdrawn amount as soon as possible to minimise the daily interest charges.

The importance of understanding overdraft terms and conditions

The charges associated with overdrafts can lead to added financial constraints for the account holder if they are not managed properly. It’s important to read and understand overdraft terms and conditions and to make use of this type of short-term borrowing only when necessary.²

Overdraft alternatives

Overdraft facilities are not the only solution for managing short-term cash flow needs. Other options include:

• Credit cards. When faced with unexpected costs, people may use a credit card as an alternative. Depending on the credit card’s interest rates and credit limit, it can help to meet short-term financial needs. The amount charged needs to be paid back within a certain timeframe to avoid interest and a customer needs to make a minimum monthly repayment.
• Other lending options. In some situations, individuals may consider personal loans, peer-to-peer lending, or payment installment options. These may help with short-term cash flow, but they may also come with disadvantages and risks that need to be taken into consideration.
• Savings. If possible, it's a good idea to put money aside to build a financial buffer for emergencies.

Before choosing any short-term borrowing option, it’s important to understand each financial product and the terms and conditions that come with it.