Overdrafts can be expensive ways to borrow money. Here’s how to clear one.
Half of all bank customers use an overdraft when they’re short of cash. Yet many don’t realise that when they use one it’s a form of borrowing. Yep, it’s debt!
But since people don’t see it as such (some even think of it as free money to spend until the next payday), they don’t treat the debt in the same way they would credit cards, loans and other borrowings.
What is an overdraft?
An overdraft is a way to borrow money from the bank without getting a loan or credit card. These can be authorised and unauthorised. Authorised simply means you’ve agreed one in advance with the bank, often with a set limit. Any use above this or if you don’t have one arranged puts you into an unauthorised overdraft.
They can be handy for occasionally dipping in to avoid payments and bills bouncing, but it’s easy to drift into it over the months. And the more you use one, the more money it costs.
It’s also one of the big revenue earners for banks. In 2017 they made more than £2.4bn from overdrafts. This money helps fund things like fee-free accounts, switching incentives and interest rates, as well as build up the profits for the bank – all at the expense of those struggling with their finances.
How much can they cost?
The simple answer is potentially a lot of money. The fuller answer is more complicated. That’s because all the banks have different systems. It could be a flat charge for each day you are overdrawn, it could be an interest rate, perhaps a few pence per pound overdrawn, or it could be a mix or some other system.
This has made it tough to understand what you are actually paying if you use one. And you might not realise that it could easily be costing you as much as 50% APR. That’s a hefty rate of borrowing – much higher than most credit cards. I think that’s something people are likely to be surprised about.
How overdrafts are changing
But this is going to change. The regulator, the FCA, has ruled that the banks must have one simple system for charging for an overdraft. This will mean a single interest rate which you can compare, and no more daily or monthly fixed charges.
Nationwide has already announced it’s rate, which will come into action in November 2019 on most of its accounts. The current authorised rate on a FlexAccount is 18.9%, but the new rate will be 39.9% for all customers using an overdraft. That will mean some customers will pay more to borrow via an overdraft – Which? says this will apply to around two-thirds.
All the other banks have to bring in this simplified rate by 6th April 2020.
Banks also can’t charge more for an unarranged overdraft than an authorised one, essentially meaning there won’t be a difference between the two – though in all likelihood it could mean you can’t use any unarranged overdrafts.
As well as these changes banks will also have to look for persistent expensive debt, try help. It’s not clear yet what this could be, perhaps it’ll see freezing of interest rates on overdrafts for those really struggling, or perhaps offering a cheaper loan to cover the debt.
However, since there’s ages before these rules begin for all banks it’s best to take action now to reduce the cost of your overdraft.
How to clear your overdraft
The best way to beat these costs is to clear the overdraft and get your bank balance back in the black.
If you have savings, you’re better off using them to clear your overdraft. The interest you’re earning on them will be far, far worse than what you’re being charged. If are worried about what would happen if you have an emergency later on having cleared out your savings, you can then look to borrow money. But there’s no point borrowing, and being charged for it, when you don’t need to.
Have some leaner months
If the overdraft isn’t huge, then it might not take long to clear it by drastically cutting back your spending over a few months. Once it’s back to zero, make sure you don’t dip back into it.
Open a new bank account
The big tip from Sara Williams at Debt Camel when she guested on my podcast was to open a separate account for day to day spending – essentially starting afresh. The old account would stiill have the overdraft debt, but you could then focus on clearing it without also trying to work out how your bills and spending impacted it. Ideally set up a set amount to transfer over to the debt each month, and top it up with more cash when it’s available.
How to reduce the cost of your overdraft
Well, first don’t wait. Every day you’re in an expensive overdraft it’s costing you cash.
Move to a cheaper overdraft
You can switch bank accounts even if you have an overdraft – though the new bank has to agree to offer you a new overdraft. This can be dependent on how large your overdraft is and on your wider credit report.
The best overdrafts are obviously 0% ones. These tend to be quite small. First Direct has a £250 0% overdraft, but there aren’t many others out there and the new rules could seem them disappear. For example, the Nationwide FlexPlus £250 buffer is going in November.
If a 0% one isn’t available, you can see what you’d get charged for an authorised overdraft at a different bank. Though it can be hard to compare (hence the new FCA rules), some will be better than others – though which ones depend on how often you are overdrawn and by how much, Still, it’s worth doing if you are spending a lot every month in fees.
The Money Advice Service has a comparison tool that can help.
Get a loan
For large amounts, you could look to a cheaper loan to clear your overdraft. You’ll obviously need to make sure you pay that loan off. If your credit rating is ok, then check out a 0% Money Transfer card. These work a bit like a 0% Balance Transfer Card, but here you move the money from your new credit card to your overdraft, and then pay that money off your card instead.
How to avoid using your overdraft
Move your Direct Debits
Sometimes people dip into the overdraft at the end of the month thanks to bills that come out. If you move them to a few days after payday, then they’ll all be covered early on. Any money that’s left is what’s available for other spending, and it’s easier to budget and not spend more than you have.
Set up text alerts
Some banks will send you a text message when you get close to a set level. This allows you to transfer money from elsewhere or just stop spending.
Download banking apps
You can now check your balance instantly via banking apps, helping you avoid spsending what you don’t have. The problem with some banks though is it can take a few days for transactions to show. New banks such as Monzo and Starling have instant updates so you’ll know exactly what is there.