In simple terms, an overdraft is the debt you go into if you spend more than you have in your current account. The moment your current account goes into the red, you step into your overdraft - unless of course your bank account does not allow any overdraft, in which case your payment will simply fail. Some accounts allow a small overdraft buffer, for example £10 or £20, before overdraft fees are charged.
There are two types of bank overdraft. If your current account provider has previously agreed that you can go into debt, i.e. an overdraft, you will go into an arranged overdraft. Going over an arranged overdraft, or going into debt where there is no arranged overdraft, on the other hand, is called an unarranged overdraft.
Providers usually charge different fees for arranged and unarranged overdrafts; arranged overdrafts generally result in smaller fees, or even none at all. That's why you should always apply for an overdraft if you can, as unarranged overdraft charges can accumulate quite quickly.
For instance, if your provider charges you a fee of £5 per day for an unarranged overdraft and it takes you a week to pay off the debt, you would then owe your provider £35. Sometimes, this would happen even if you go just a few pence below zero.
This example also illustrates that in most cases it's better to pick an account with an interest rate charge instead of a flat daily fee, with a 5% interest rate remaining cheaper than £5 until you go more than £100 into the red, even if both were calculated daily. And unlike most flat fees, interest rate charges tend to be calculated on a monthly basis, so you'd need to stay £100 in the red for seven months to owe your provider the same £35.
Of course, you'd rather not pay your provider anything at all and keep your money. That's why it's so important to consider the overdraft when choosing a current account, especially as some providers charge both interest and a fee.
If you frequently find yourself dipping into the red, an account offering an interest and fee-free overdraft would seem ideal. However, it's important to look at more than just the overdraft charges to find the right account for you. Some may charge a monthly fee, which could outweigh the benefits of low (or no) overdraft fees, while others may have additional benefits that could make up for having some overdraft fees attached.
What to look out for when comparing current account overdrafts will depend on your specific circumstances - particularly how often and how far you are likely to venture into your overdraft. For some, a small interest-free overdraft buffer might be sufficient, as it would mean that you wouldn't get charged any interest if you only go £10 or £20 into the red. Others, who are more likely to go into larger debt, will need to look at the overall interest rate charged on the account.
The EAR could be useful for comparing interest rates. It refers to the Equivalent Annual Rate, which looks at the interest you would be charged if you were to remain overdrawn for an entire year. It also compounds the interest, which is why it can look quite steep.
If you regularly find yourself in your overdraft and you're tired of paying expensive fees as a result, it may be time to switch to an account that offers a cheaper overdraft option. You will need a decent history of paying off your overdraft and other debts within a reasonable timeframe, however, otherwise providers will be reluctant to let you bank with them and use their credit facilities. If you have a bad credit score, a basic bank account or even a guaranteed account (which does not require a credit check) might be a better fit for you.
For those with a decent credit score who would like to have low or no overdraft charges, even if they never intend to go into the red, there are some advantages and disadvantages to consider.
You can apply for a current account with overdraft as you do for any other current account, by talking to the provider you want to move to. If you're looking to switch your current account over entirely, the Current Account Switch Service should be a great help, as it automatically moves your direct debits and standing orders to your new provider, meaning you don't have to worry about missing payments.
Before you apply for anything, however, remember to check your credit rating. Your credit score at the time of application will greatly affect whether you get the account or not, so if there's anything you can do before applying to improve it, don't hesitate.
Also remember that changing your bank account will likely reduce your credit score slightly, due to the credit check that will be part of the application, so be sure of which account you're after before you apply and don't immediately apply for a different account if you get rejected.
Remember that different providers will have different overdraft limits, so if you are looking to use an overdraft for a somewhat larger debt, check what limit a provider offers. This may be influenced by your credit score and will likely not be the cheapest way to borrow money.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.