How Exactly Does An Overdraft Work?

March 20, 2013

If you are financially independent, it’s more than likely that at some point in your life, your outgoings will exceed your income. Of course, this isn’t so bad if you have savings in place. However, if you don’t, how are you supposed to pay for the basics – food, water, rent and all the rest of life’s little necessities?

What is an overdraft?

The best answer to this question is simple: an overdraft. An overdraft can be attached to almost any bank account and can help you get by in times of financial need. Once your bank account is empty, rather than leaving you embarrassed and with a card that has been declined, the overdraft provides you with an emergency supply of funds that you are obligated to repay to the bank.

How does it work?

Overdrafts work by giving account holders access to additional money and are essentially a form of credit. Like other types of loan or credit agreements, the borrowed amount must be repaid by a set date and will usually incur interest if used.

How much will my overdraft be for?

Provided you have a good financial history, your overdraft could be thousands of pounds. However, those with a poor financial history or low income will consequently only be permitted a smaller overdraft, as they are more likely to struggle when paying it back.

Many people also choose to have a lower overdraft limit than they are allowed, as this removes the temptation to overspend. Anyone thinking of making a big purchase could benefit from a large overdraft limit though, as long as they are confident that they can pay it back.

How much will it cost to repay?

Most overdrafts, should you need to make use of them, will incur charges on the amount of money that has been borrowed from the bank.  Typical figures for overdraft charges can be between 1% and 5% per month on the money that you have borrowed.

Alternatively, instead of a percentage fee, some banks and bank accounts will instead charge a flat fee for going into your overdraft. Once again these figures can range wildly, but reputable banks will only charge you a minimal amount.

Some premium bank accounts, usually those which charge a fee for members, as well as most student accounts, offer a certain amount of the overdraft that can be utilised without incurring any charges.

For instance, many student accounts offer £500 interest-free overdrafts for each year of study. This usually leaves the student with a £1,500 interest-free overdraft by the time they finish university – hopefully without squandering it all on partying and junk food. The overdraft will subsequently be reduced in each year after the student’s studies have been completed.

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