How does an overdraft work?

At Kroo we’re on our way to becoming a licensed UK Bank. A bank that wants to change the relationship people have with money for good. With this comes a big responsibility, one we take seriously. Just one step we’re taking is to give people the confidence to make the right financial decisions.

Over the coming months we’ll be covering banking topics that tend to cause uncertainty and confusion. The articles will be short, simple, and give you the confidence to know your APR from AER.

How does an overdraft work?

An overdraft is simply part of a current account. Not quite.

Many people misunderstand how an overdraft works, and where it fits into their personal finances. In its simplest form an overdraft should be understood as a way you can borrow money from the bank. An overdraft does this by extending the amount of money you can access through your current account. So when your balance reaches £0, if you have an overdraft, you can still spend or pay bills from your current account. When you are using the overdraft in this way your account is ‘overdrawn’.

Of course the amount you can spend beyond £0 balance, depends on the overdraft limit you have in place on the account. An overdraft can be a useful tool to deal with unexpected costs, tide you over during expensive months, or simply give confidence in case of an emergency expense. What’s important is that an overdraft is seen as short term access to extra cash. If they’re used for long periods they can quickly become expensive.

It’s important to remember that when your account is overdrawn you are borrowing money which will have to be paid back. Like most money borrowed from a bank, the amount borrowed might be subject to interest, and fees. Normally, any interest and fees are bundled together and shown as a single value, which is written as a %. This is called the ‘APR’ or annual percentage rate. An APR is designed to give a good indicator of the actual cost of using an overdraft. The APR applied to an overdraft can vary greatly between banks, and between customers within the same bank.

You might have heard of arranged and unarranged overdrafts. An arranged overdraft simply means the bank has authorised you to spend up to an agreed amount once your current account balance reaches £0. As an example, you may have an arranged overdraft of £500. Once your account balance reaches £0, the bank allows you to spend a further £500 on that account taking your balance to -£500.

The cost of using this overdraft is calculated daily, so the amount you are overdrawn and the time you are overdrawn as well as the overdraft APR all affect the overall cost to you. You can get a feel for how this works by looking at a bank’s overdraft calculator online.

Using an unarranged overdraft means your balance has dropped below £0, but you have no overdraft limit agreed with the bank, or when your balance falls below your agreed overdraft limit. Banks used to be able to charge higher rates if customers used an unarranged overdraft but the rules on this were recently changed. Now banks must charge the same interest whether the overdraft is arranged or unarranged.