How does a current account overdraft work?

An overdraft is when your bank account balance goes below zero. Usually you will agree an overdraft with your bank in advance up to a specific limit. An overdraft is a form of credit, which means that any money you use from your overdraft is money you owe to the bank. When you use an overdraft, this can incur an interest charge from your bank.

An overdraft may be offered to you as part of opening a bank account or you may need to apply for one from your bank account provider. The amount of your overdraft will depend on your personal circumstances, including credit score, income and outgoings. Usually there is no charge to arrange an overdraft. You will likely incur interest charges when you use your overdraft.

There are two types of overdraft: arranged and unarranged:

• Arranged overdrafts or authorised overdrafts are pre-agreed and allow you to go overdrawn (or borrow) up to a certain limit, charged at a set rate of interest.

• Unarranged overdrafts or unauthorised overdrafts are not pre-agreed. This may be because you don't have an arranged overdraft at all, or you have gone over your arranged overdraft limit. The bank or building society may honour your payments, although they will probably charge you a fee for doing so. Banks can no longer charge more for unarranged overdrafts than for arranged ones, but could still negatively affect your credit score. If you know you're going to creep into an unarranged overdraft, try contacting your bank in advance to see if you can arrange or extend a temporary arranged overdraft instead.

Overdrafts incur an interest charge – this is called the equivalent annual rate (EAR) and range from 0% up to 39.9%

In some cases, banks will have a zero rate overdraft tier on an authorised or arranged overdraft up to a set limit. You must check with your bank if your account has this facility.

Unarranged overdrafts will have the same fee structure.

The FCA announced changes to how overdrafts are priced and offered to the public in June 2019. It immediately made banks and building societies ensure that any refused payment fees would correspond to the actual costs of refusing payments. The remaining changes came into force on 6 April 2020 and include:

• Unarranged overdrafts can no longer be priced higher than arranged overdrafts
• A ban on fixed daily or monthly overdraft fees
• A ban on fees to have an overdraft available
• The use of a simple interest rate (EAR) for overdrafts
• Mandatory use of annual percentage rates (APRs) for overdraft pricing on advertising
• More action to identify those who show signs of financial distress and to implement strategies to reduce repeat overdraft usage.

From April 2020, overdrafts can only come with an interest rate charge – all fixed charges have stopped. Overdrafts are a form of borrowing from your bank or building society, so it's important to compare the EAR interest rate as well as the advertised APR before you choose a current account. They are open-ended so don’t have a specific end date when the debt must be repaid.

The table below shows some of the accounts that have confirmed pricing under the new regulations and the difference in cost for an overdraft under the current and future pricing.

Overdrafts should be used as a short-term credit option. They can be a useful buffer in emergencies but when used repeatedly may be a sign of a larger financial problem and could prove more costly than an alternative source of credit.

It’s always better to have an arranged overdraft than to go overdrawn without agreement from your bank. If you find your overdraft balance creeping up or staying the same, month after month, take action and read this guide to repaying your overdraft.

However, if you use your overdraft sparingly and pay it off within a couple of months, make sure your current account is competitive by checking out our selection of the best overdraft current accounts.

It is possible to switch your current account while you are overdrawn.

• Compare and find accounts with overdrafts.
• Being accepted for a new bank account will depend on your personal finances and credit score.
• Read more about switching bank accounts.

Current account providers are now required to include tools on their websites to help you assess your eligibility for an overdraft before you apply.

An overdraft may be removed by your bank or building society at any time without notice. This could leave you with less money than you had planned for and may result in you missing certain payments or incurring additional charges. 

Here are some suggested alternatives to overdrafts:

If you dip into your overdraft because of occasional retail spending, consider using a credit card instead.

You get an interest-free grace period of up to two months on a credit card (which you don't get from an overdraft) plus the added benefit of purchase protection on purchases between £100 and £30,000. Just be sure to clear the balance in full and by the payment due date.

If you find you are using your overdraft more and more frequently or if you want to make a larger purchase, then a personal loan may prove to be more effective to borrow and pay back your debt in the longer-term.

However, payday loans should only be considered as a real last resort as they can charge significantly higher annual rates of interest!