Overdrafts are a topic that divides opinion. Some people love them and make use of them either on an infrequent or frequent basis, whilst others feel that they are a great evil and go to great lengths to avoid them. Part of the reason for this difference of opinion is to do with confusion around what exactly an overdraft is. This isn’t helped by the fact that the word overdraft’ is used to describe two distinct scenarios. This article clarifies what those two types of overdraft are and will hopefully convince you that there are good and bad overdrafts.
The first type of overdraft is an authorised or agreed overdraft. This is where you speak to your bank and they agree a limit that your allowed to take your balance to. For example, if I have a 500 overdraft, this means that I can take my balance to -500 and still be within the boundaries of what the bank has allowed me to do.
Typically, authorised overdrafts do not incur charges. I will, however, be required to pay debtor interest on the amount that I have, in effect, borrowed. This is why, even with an authorised overdraft, it is important to try to avoid going overdrawn, or to at least use the facility sparingly.
As the name implies, an unauthorised overdraft is where I exceed my account limit without having prior agreement from the bank to do so. So, if I have no agreed overdraft on my account and my balance drops to -1 or less, then I am in breach of my account terms and conditions and the bank will be entitled to levy unauthorised overdraft charges. Another example would be if I had that agreed overdraft limit of -500 and my balance went to -501.
Typically, the charges applied for unauthorised overdrafts are very steep. There will usually be a flat fee applied for breaching your limit. And, additionally, you may incur additional paid referral’ or unpaid items’ charges for transactions that you attempt to put through whilst in an unauthorised overdraft. A paid referral charge is where the bank decides to allow the transaction to go through, even though you’re in breach of your account limit. An unpaid item charge is where the bank decides not to allow your transaction to go through.
Finally, you will also incur an unauthorised overdraft debtor interest rate. This will typically be much higher than the authorised overdraft interest rate.
All in all, then, exceeding your agreed account limit can be a costly business. It is also very contentious (especially in the UK at present) with banks accused of applying charges that are out of line with the effort that’s required to administer the account transactions.
I mentioned that there can be said to be both good and bad overdrafts. Unauthorised overdrafts are obviously bad and will hit you in the pocket quite severely. Authorised overdrafts can, however, be a very useful addition to your checking/current account. You should still try to avoid dipping into an authorised overdraft, as they will cost you in terms of debtor interest. However, they are a very useful buffer zone to protect you from the peril of going into an unauthorised overdraft. And there are also times when it is undoubtedly useful to dip into your authorised overdraft (as long as it’s only temporarily) rather than having to put the money on an expensive credit card or take out a loan.
Finally, for those who are totally opposed to the thought of going overdrawn, you may be able to find a basic banking account that simply doesn’t allow you to go below a zero balance. Certainly in the UK, these are offered by all the main banks. The downside to them is that you won’t get a debit card, so they will not suit most peoples’ needs.