What is an Overdraft?

Revolut Contributor

 · April 06, 2020  · 04/06/2020

What is an overdraft and how does it work? How do you pay off an overdraft? What is an arranged overdraft, and how does it differ from an unarranged overdraft?

Discover the answers to all of your overdraft questions in this blog post.

What is Overdraft? With an Example...

Overdraft definition: Think of an overdraft as a means of borrowing a limited amount of money from the bank in the short-term. An overdraft allows you to continue drawing money from your account after the balance hits zero, and it can offer a reprieve if you need to boost cash flow temporarily. Banks charge interest on the overdraft “loan” they offer you, usually in conjunction with some sort of overdraft fee.

If money runs out at the end of the month, perhaps before payday, a person might need to consider having an overdraft. It can be one one method of surviving through a tricky financial patch.

Another example: if somebody is laid off from their job, there may be an interim period before they start a new job or secure their benefit payments. If their outgoings remain the same, they might temporarily need more money than they’ve got in their bank account. This is when an overdraft can come to the rescue. It can provide the breathing room whilst the person gets back on their feet.

To fully understand how an overdraft works, it’s important to know the distinction between an arranged and an unarranged overdraft...

What is an arranged Overdraft?

Quite simply, an arranged overdraft is an overdraft which is agreed before someone has insufficient funds in their account. They can agree a certain amount with their bank, or the bank will provide it as an automatic feature of the account. The fees and interest will typically be lower with an arranged overdraft vs unarranged overdraft, so foresight can be really useful here.

What is an unarranged Overdraft?

An unarranged overdraft is when a bank account goes into overdraft without prior planning in place. This might be because somebody continues to withdraw from the account after their balance reaches zero, or it might be after reaching the limit of an arranged overdraft. While in certain circumstances this may be unavoidable, an unarranged overdraft can result in numerous future costs – interest charges and fees.

How do you pay off an Overdraft?

Put simply, overdrafts are paid off through increasing the balance of a bank account; by paying money into that account to raise the balance into the green. Here are some things to consider:

  • Usually, the longer an account remains in the red, the greater the bill from the bank
  • Banks can change their terms and conditions on overdrafts, but they must inform you
  • It may be possible to negotiate personal overdraft terms with your bank, but not always
  • You can switch current accounts to get better overdraft terms, even when you are in the red
  • You could use a money transfer credit card to pay off an overdraft, but they usually charge transfer fees and the interest can be very high after an initial 0% grace period

Is it bad to have an Overdraft?

Remember: By using an overdraft, you are borrowing money from the bank that should be paid back.

No, it is not “bad” per se to have an overdraft. But an overdraft can become a problem if it isn’t kept under control, because it will create unwelcome charges and cause a buildup of interest.

If someone doesn’t use their arranged overdraft, there’s no harm in having it there as a buffer in case of unexpected outgoings or unforeseen events. And there is no “shame” in having an overdraft. According to Finder, 26 million British people use an overdraft every year. Life can be expensive, and it will throw a few curveballs along the way. A planned overdraft might provide some peace of mind, but it’s up to you.

Hopefully we’ve answered your question, “what is an overdraft?” but if you want to learn more about common money queries, check out these blog posts:

Disclaimer: This is part of a series on general financial literacy from Revolut and we will not in all cases offer the relevant product.