An unprecedented contingency can put your finances to test. Sometimes, you may have to spend more than what your bank account can cover. In such situations, an overdraft arranged with your financial institution may aid in alleviating your stress. We’ve answered some of the most commonly asked questions about Overdrafts, to help you make an informed financial decision.
What are overdrafts?
An overdraft is a facility provided by financial institutions, wherein an account holder with zero balance can continue to withdraw from the bank. An overdraft arrangement with your bank allows you to withdraw money even with insufficient funds to cover the requested amount.
Overdraft protection can be referred to as a loan provided by a bank to their account holder, on a zero balance account. Therefore, just like any other loan, you are required to pay interest on your overdraft. This interest may vary from one bank to another, but they generally range from 19% to 40%.
How do overdrafts work?
An overdraft would essentially allow you to go into a negative bank balance, as you’ll be able to make transactions from a zero balance account. For instance, you have an account with zero balance, and you spend £50 from the same. Now your account balance will drop to -£50, indicating that you’ve entered into an overdraft.
There are two types of overdrafts that you can use, depending on what your bank permits:
Authorized overdraft: Overdrafts that are arranged with your bank in advance are called Authorized overdrafts. Your agreement with the bank will define a monetary limit, and the interest rate levied on your overdraft. Some banks may charge an extra fee apart from the interest. If you spend beyond the arranged spending limit, your overdraft will become unauthorized.
Unauthorized overdraft: Sometimes, you may unintentionally spend money from an account with insufficient funds to cover the cost. This ‘unplanned’ or ‘unarranged’ overdraft is called an Unauthorized overdraft.
For how long can I have an overdraft?
Just like lenders offer revolving credit, banks offer overdrafts. So unlike a loan, the terms of repayment are flexible. You can even add to an ongoing overdraft or repay it in full and then arrange a new one. As long as your bank authorizes your overdrafts, you can avail and cover the cost.
Are there any latest changes in overdraft regulations?
In light of the recent events, involving the Coronavirus pandemic, the FCA has eased it’s overdraft regulations to mitigate people’s financial hardships. The following came into enforcement from April 9′ 2020:
- Banks will offer an interest-free overdraft up to £500, for the first three months.
- FCA urges banks to identify people who are continuously seeking an overdraft and provide them with the right financial assistance.
- If banks are to change their overdraft interest rates and fees, the changes must comply with FCA’s guidelines in response to Covid-19.
Can I switch between banks with an overdraft?
An overdraft doesn’t hinder your plans of switching your current account to another bank. Whenever you wish to make a switch, simply apply for an overdraft during the process. The new bank will then evaluate your credit history and will either deny or provide you with the overdraft facility.
What if I can’t pay back?
These are unprecedented times, so if an overdraft repayment overwhelms you, sit back and contact your bank. If you sincerely inform your bank, they can help you devise a plan before the situation worsens. Taking debt advice won’t magically waive off everything, but will certainly give you a practical outlook to deal with it.
What impact will an overdraft have on your credit score?
Overdrafts are known for their flexible repayment plans. Banks report your repayment history to credit bureaus every month. If you maintain a healthy payment history towards your overdrafts, there will be no impact on your credit score.
However, not adhering to your authorized overdraft spending limit and constantly missing payments, can have a drastic impact on your credit score. We advise you to keep up with your repayments and refrain from overspending from an overdraft account.
What’s better: Taking out a loan or Starting an overdraft?
While overdrafts are useful for covering short-term financial problems, loans are usually ideal if you require a substantial amount at an instant. Besides, borrowing money through a loan may be cheaper than starting an overdraft due to the high-interest rates charged on them, if you’re planning to borrow over a longer-term. Some loans come with a fixed interest rate, unlike the interest on overdrafts, which is subject to change as per the bank’s convenience. A major upside of overdrafts, however, is that they provide flexibility in repayments.
Some tips to deal better with your overdraft:
- Keep an eye on the balance of all your existing bank accounts.
- Ensure timely repayment towards your overdraft every month.
- Create a budget to minimize the use of overdraft – once you start it, you may mistake it as your money. Do keep in mind that overdrafts come with an interest.
- Regularly check your credit score and look for any discrepancies.
- Compare the cost of all forms of credit available – overdrafts can be a lot more expensive than a promotional credit card, or personal loans.
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