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What is a bank overdraft?

In the UK, a bank overdraft is an agreement with your bank that allows you to borrow money from your current account.

Overdrafts are a popular financial tool, but it’s important to understand how they work and manage them effectively to avoid unexpected fees and potential negative impacts on your credit score.

How do bank overdrafts work?

Overdrafts work in a very simple way: you spend more money than you have in your account. When this happens, your account is considered “overdrawn” or “in overdraft.”

This is really just another way of borrowing money from your bank. The bank charges interest on the borrowed amount, which is usually calculated daily and added to your account balance.

This is often used for short-term financial needs, such as unexpected bills or expenses.

How many kinds of bank overdrafts are there?

Overdrafts can be arranged in advance or can occur unexpectedly. This means that there are two types of bank overdrafts: arranged and unarranged.

An arranged (also called “authorised”) overdraft is a pre-agreed limit with your bank, allowing you to spend more money than you have in your account. This type of overdraft is typically used for planned expenses or financial emergencies. You’re not forced to use it – it’s just there for your peace of mind.

On the other hand, an unarranged (or “unauthorised”) overdraft is when you spend more money than you have available in your account without having a prior agreement with the bank. An unexpected charge, for example, can send your account into an unarranged overdraft.

Because they’re unplanned, unauthorised overdrafts usually have higher interest rates and fees than authorised ones.

They can also damage your credit score.

If you can repay what you owe right away, your credit score may stay safe. But if you can’t, the bank might report the credit reference agencies about your unpaid overdraft. If you take too long to pay, it could look like you have missed a payment on your credit report, which lowers your credit score and stays on your credit report for six years.

To prevent this, think about setting up an arranged overdraft in advance.

What are the pros and cons of bank overdrafts?

Overdrafts offer several advantages:

  • Overdrafts can be a lifeline if you have an unexpected expense or financial emergency.
  • It’s easy to set up an overdraft. You can usually get one through your bank’s app or by visiting a bank branch.
  • An overdraft is technically a loan, yet one that doesn’t always require a hard credit check. If you’re asking for an overdraft, your bank often has to run a credit check. But just as often, your bank might offer you an overdraft facility without checking your credit file. This is great if you want access to more money but don’t want another hard check, which can hurt your credit score.

Despite these benefits, overdrafts also come with quite a number of disadvantages:

  • Overdrafts usually have high APR. The interest charges and fees can add up quickly.
  • They are also more challenging to manage. A loan usually involves some planning from your side. An overdraft might leave you with an unexpected debt to pay, which you haven’t accounted for properly.
  • Unauthorised and poorly managed authorised overdrafts can lower your credit score, making it harder to secure loans or credit in the future.

How to use a bank overdraft properly?

To avoid the risks that overdrafts come with, you must learn how to manage them properly. Here are some tips:

  1. Try to get a current account that offers an authorised overdraft facility without needing to ask for it. This will save your credit file from an unnecessary hard credit check.
  2. Only use an overdraft when you absolutely need to.
  3. Create a budget and see where you need money, then apply for a personal loan or credit card instead of an overdraft. The APR for these is quite a lot lower.
  4. Check your current account balances regularly to make sure you didn’t accidentally go into overdraft.
  5. When you have an overdraft, try to pay it off as soon as possible. This will keep interest charges and fees lower.
  6. If you ever have an unauthorised overdraft, pay it off before any other debt repayment you might have. If you don’t, it might appear as a missed repayment on your credit file.

In short, don’t treat a bank overdraft like a tool you should use regularly. It’s great to have one available in case of emergencies. Still, otherwise, it’s too expensive and difficult to manage and not a real alternative to a personal loan or a credit card.

Set a budget, check your account balances, and pay off the overdraft as soon as you can to save on fees and keep your credit score intact.

Finally, keep in mind that a bank overdraft is not a credit-building tool.

If you want to improve or build your credit history, consider downloading a credit-building app like Wollit. Unlike an overdraft, Wollit helps you build your credit history by reporting a fixed fee subscription as a loan repayment to the credit reference agencies.

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Terms apply. Results may vary. Improvements to your credit score are not guaranteed. Wollit Credit Builder plans are unregulated.

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Terms apply. Results may vary. Improvements to your credit score are not guaranteed. Wollit Credit Builder plans are unregulated.