An overdraft is a service provided by a bank which allows a customer to continue to make payments or withdrawals from an account even when there is not enough money in the account to cover them. In effect, an overdraft is a form of credit, which attracts interest charges for as long as you are overdrawn.

Are there different kinds overdrafts?

Yes, there are authorised and unauthorised overdrafts.

An authorised overdraft is one where your bank has agreed that you can have an overdraft, which exists for you to take advantage of at any time within an agreed period, up to an agreed amount. It costs you nothing in interest charges if you do not use it.

On the other hand if your account goes overdrawn without the bank’s permission or you exceed the limits set in an authorised overdraft, then this is an unauthorised overdraft.

The bank is not obliged to give you an unauthorised overdraft. As a general rule, when you do not have an authorised overdraft in place, then any cheques or withdrawals for a sum higher than the amount available in your account can be ‘bounced’. This mean the bank may not honour them and may make a charge for returning the item.

How much will my overdraft cost?

The size of an overdraft depends on how much more you have taken out than you have in your account and therefore it is not always easy to predict how much an overdraft will cost you. Most overdrafts are charged at variable interest rates; that is, the rate charged goes up and down depending on what base interest rates are at the time.

Charges may be calculated daily, monthly, quarterly or even annually. In every case, your bank is obliged to tell you in advance how it intends to charge, what interest rates it will apply, and how and when interest will be levied.

Do different interest rates apply to unauthorised overdrafts?

Yes, it is often the case that your bank’s interest rate for unauthorised overdrafts will be higher than for an authorised overdraft. This is partly a penalty to discourage customers from taking more money out than they have in their accounts without agreeing to do so first. It also reflects the increased risk to the bank. A bank’s duty to other customers means that it has to be able to manage the risks of lending (including overdrafts) first to meet the needs of people who are making withdrawals from accounts in credit, before meeting the demands of unauthorised withdrawals.

How do I apply for an overdraft?

If you believe that there are likely to be times when the funds available in your account will not meet your expected outgoings for a short period, then you should contact your bank and discuss whether it would be possible to have an overdraft facility.

How does the bank decide my overdraft limit?

A decision will be made by the bank usually based on your income, assets and other earnings, compared with your likely outgoings and commitments. Credit scoring techniques may also be used to assist decision making [LINK to credit scoring section].

You may find that your bank makes a charge for setting up or arranging an overdraft facility. This is in part to cover the costs of analysing your situation to see what amount is suitable. Overdrafts are a service tailor-made by the bank to suit your situation, rather than an off the peg product; it takes time and effort to make sure it is right for you.

What right does a bank have to alter my overdraft?

Your bank will have set out your overdraft limit and repayment arrangements based on an assessment of your needs and your ability to repay. If there are changes in your circumstances, these will need to be reflected in your overdraft arrangements. An overdraft facility is therefore available for you to take up at any time within an agreed period, to the full amount set by your limit. In return for this flexibility, the bank has a right to withdraw the facility at any time or to require immediate repayment in full.

How is an overdraft different from a bank loan?

bank loan is a set amount of money which the bank agrees to lend you for a set period of time. You agree to repay it, with interest, by the end of that term, either through regular repayments or in a lump sum at the end.

An overdraft facility means that you can borrow up to an agreed level at any time while the facility is in place, but there is no set repayment programme; it is designed to be dipped into and out of when necessary to cover short term cash shortages. It is a very flexible form of borrowing but is not suitable if you need to borrow money over a long period of time.

When is a bank loan better than an overdraft?

Some bank loans can involve a fixed interest rate over the life of the loan, which makes their cost to you very predictable. If it does not suit your circumstances to repay an overdraft quickly or to have the bank change the terms of your overdraft, then you should consider a bank loan.

Most overdrafts have variable rates, so if base interest rates go up suddenly, you could find yourself paying a lot more than you had planned. If you are consistently overdrawn for long periods of time, you may want to consider applying for a bank loan, particularly if it has a lower interest rate.

If you need money for a large purchase like paying for a new car or a holiday, for example, you should probably consider a loan, which allows you to repay over a longer term.

Paying off an overdraft can be much more flexible; some bank loans involve a penalty if you repay early, which is not the case with an overdraft.

The key to making the best choice is to know why you need the money and for how long, as well as how you intend to repay it.