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What is an overdraft?

Current accounts exist to help manage our finances, with benefits and salaries coming in, bills and taxes paid through Direct Debits and standing orders, and debit cards used for day-to-day spending. Overdrafts are commonly used to cover times when spending exceeds the available account balance. There are two types:

• Arranged overdraft: This allows you to spend up to an agreed limit, with charges based on the amount spent using your overdraft (after your balance goes below £0). In some cases, there are no charges if you stick to the agreed limit 

• Unarranged overdraft: This occurs when you exceed your arranged overdraft limit, leading to higher interest rate charges than with an arranged overdraft. If you keep spending, at some point, your bank will block you from accessing money

How much does it cost to use an overdraft?

Since April 2020, current account providers can charge account holders a simple, annual interest rate, without extra fees or charges. While the Financial Conduct Authority states the rule change has saved customers £500 million, this doesn’t mean using an overdraft is always a cheap option. You’ll need to shop around to find the best ones on the market.

Some providers don’t charge interest on overdraft spending up to a certain amount, such as £250, but you can expect to start incurring interest charges on spending above this limit. With other providers, any overdraft spending attracts interest charges, typically of 34% to 39.9% AER, although some charge as low as 15% AER.

Why should you get out of an overdraft?

Paying interest on an overdraft – money you already owe – only pushes you further into the red. Here is why you should avoid this scenario:

• Debt management: If you don’t take steps to reduce your overdraft, the total you owe will keep rising. This is because you have to pay interest on the amount you spent and on the interest charged. For example, if you are paying 35% AER on a £300 you would owe £405 after a year. After two years, you would owe £546.75, including interest

• Unarranged overdraft issues: If you exceed your arranged overdraft limit, your account provider will either impose a capped fee (for example, £20 per month) to allow you to continue to use your overdraft or block further payments. This could cause problems if you’re unable to make certain payments, such as your Council Tax or rent

• Savings impact: If you’re constantly using your overdraft, you might struggle to save money (or you may need to exhaust your savings to pay off what you owe). Given the cost-of-living crisis and the benefit of having savings on hand for an emergency, this could make things even more difficult

• Credit score: An overdraft will appear on your credit report as a debt. By sticking within the limits and regularly paying it off, you could improve your score, because it suggests you can manage your money. Exceeding the arranged limit will damage your credit rating as it indicates you may be struggling financially

What should you do before reducing your overdraft?

When looking at how to improve your financial situation, it’s still important to prioritise. You must ensure you continue to make certain payments otherwise you could find yourself in a worse situation. Make sure you are on top of the following debts and commitments before considering anything else:

• Council Tax

• Rent or mortgage

• Gas and electricity

• Court fines

What are the easiest ways to get out of overdraft?

Having an overdraft is a handy buffer against unexpected or occasional costs and purchases you need to cover. But it shouldn’t be viewed as anything other than a short-term fix. If you can never clear what you owe, consider the following ways of getting out of overdraft:

Budget and cut back

Work out what you have coming in each month. Subtract your priority debts, then create a budget for groceries and transport costs. Draw up a grocery shopping list for the week, cut out treats if necessary, and stick to it. Forego socialising and non-essential shopping trips, and cancel TV, magazine and other monthly subscriptions. 

Use your savings

Even the best savings accounts will pay far less in interest than you’ll likely face if you're frequently in your overdraft. For example, if you’re paying 35% AER on a £300 overdraft charging, you’ll pay £105 in interest over a year. If you have £300 in an instant-access account paying 5% AER, you’ll earn £15 a year.

Switch current accounts

If the amount you’re paying in interest is proving impossible to cope with, consider switching accounts. Look for banks or building societies that will take on your debt, and reduce the interest rate you’re paying on it – ideally to zero. Switching is quick and easy to do, you just need to shop around and apply for the best bank account with a switching offer.

Transfer cash from a 0% credit card

A money transfer credit card allows you to move cash directly into your current account. If you can find one with an interest-free period, it’s an efficient way to avoid paying interest on your overdraft for a while. Just make sure you clear the debt before the interest-free period ends. 

Take out a personal loan 

If you can’t get a 0% money transfer credit card, a personal loan could be an option. These are generally suitable for loans of £1,000 or more and run for a fixed period of one or more years. The average interest rate for personal loans is between 11% and 21% depending on credit score, less than what you typically pay on an average arranged overdraft. 

Speak to your bank

If all else fails and you’re getting close to, or you’ve slipped into, an unarranged overdraft, contact your provider. It may agree to freeze interest or fees, or it may give you a monthly amount to spend on essentials and cover priority debts, but you’ll need to commit to making repayments. 

Get independent advice

Debt charities, such as Citizens Advice and StepChange, are an excellent source of advice, so don’t be afraid to consult them.

Next steps

Once you're in the clear, maintain good budgeting practices and consider opening a basic bank account or one with a low overdraft to prevent future issues.