Your account will become overdrawn if the balance of your bank account drops below zero. In some cases, people may have agreed an authorized overdraft with their bank. For example, your bank may have granted you a $1,000 authorized overdraft limit. Provided your balance stays within that agreed limit, then the main consequence will be that you will probably be charged debtor interest on the amount that is overdrawn. However, if you don’t have an agreed overdraft, or go beyond your agreed overdraft limit, then you will be said to have incurred an unauthorized overdraft. This will almost certainly have bad consequences for your credit rating and may lead to hefty bank charges and unauthorized overdraft debtor interest.
Authorized (or agreed) overdrafts normally have to be applied for and are “subject to status”. What this means is that the bank will assess whether they are prepared to offer you an agreed overdraft facility and this assessment will be done through a process called credit scoring. They will ask for certain details about your finances, such as any credit card balances that you hold, and will then advise on whether they are prepared to offer you an authorized overdraft and, if so, what the limit will be.
Even if you obtain an authorized overdraft it is still advisable to do your best to avoid going overdrawn. There are several reasons for this. Firstly, it just makes good common sense to try to maximize the amount of money that you have in your bank account, and to transfer any surplus funds into high interest paying savings accounts. You should seek to be in a position where your bank pays you rather than you paying your bank! Secondly, although an authorized overdraft will normally protect you from the worst excesses of bank charges, you will be required normally to pay debtor interest rate on the amount that you are overdrawn by and this can become a drain on your monthly finances. Finally, slipping into your agreed overdraft takes you one step closer to reaching an unauthorized overdraft position which can be very painful on your financial health.
An agreed overdraft is a useful buffer against going into an unauthorized overdraft position but it’s important to still view it as an option of last resort rather than as a lazy extension to your monthly income. Some discipline is required to make sure that your agreed overdraft works for you instead of against you.
Any time that you move into a negative balance that hasn’t been authorized by your bank, then you will be said to be in an unauthorized overdraft position. The banks tend to take a very dim view of this as it exposes them to the prospect of bad debt. i.e. you’ve effectively borrowed money from the bank without the bank’s consent and the bank is exposed to the risk that you may not pay the money back.
As a consequence, banks apply a range of bank charges to penalise customers who find themselves in an unauthorized overdraft position. Typically, this may include a hefty monthly service fee, plus unpaid item and/or paid referral fees. Unpaid item charges are where you are in an unauthorized overdraft and then attempt to put through another transaction only for the bank to reject it. Paid referral charges are where the bank allows a transaction to go through despite the fact that you are in an unauthorized overdraft.
Additionally, banks normally charge a higher debtor interest rate on unauthorized overdrafts than they do on agreed overdrafts. There has been a lot of media coverage (and court cases!) of overdraft charges in the UK and some banks have changed their charging practices in response to criticism. From a consumer’s perspective it’s always worth checking to see what the charging structure is on your checking/current account, but the cardinal rule is that the best way to avoid charges is not to go overdrawn!
Impact upon your credit score:
Credit scoring doesn’t just determine whether you are eligible for an agreed overdraft; it is also used to determine eligibility for other debt facilities such as credit cards, personal loans, and mortgages. Any time that you get into unauthorized debt, miss payments, and/or incur bank charges it leaves an imprint upon your credit rating. The consequences can be very damaging. For example, a young person who constantly incurs unauthorized overdraft charges due to poor financial discipline may then find at a later point that they are rejected for a mortgage when they want to buy their own home. Avoidance is the best practice but if people do go overdrawn then every effort should be taken to bring the account back into an agreed position as soon as possible and to pay off all charges immediately.