Navigating the world of personal finance can be filled with unexpected twists and turns, and one common hurdle is the overdraft. In this article, we'll shed light on what an overdraft is, how it can impact your financial well-being, and strategies to help you navigate overdrafts in your banking journey.
What Is an Overdraft and How Does It Work?
An overdraft occurs when your bank charges exceed the available balance in your account. In other words, you are spending more than you have in your bank’s checking account. Even though you have insufficient funds in your account, the bank may still allow the transaction. Typically, the bank will charge an additional fee when you overdraft your account.
Account holders can opt in or out of overdraft protection. If you opt out of overdraft protection, you can set your overdraft limit, which typically ranges between £500 and £2,000. Overdrafts work similarly to short-term loans. Often, individuals will overdraft their accounts to cover emergency expenses or bills.
Overdrafts, just like other forms of loans, have their own advantages and disadvantages. In this guide, we’ll explore overdrafts in more detail, whether or not one is right for you, and what some alternatives may be.When setting up your current bank account, you are given the option to opt-in or out of overdraft protection. If you choose to set up overdraft protection, transactions will automatically decline if you do not have sufficient funds to cover them.
Conversely, if you opt out of overdraft protection, you may choose to have an overdraft limit of £500. In this case, you may borrow up to this amount.
Typically, each bank will set its overdraft limit. Therefore, always check with your bank regarding their regulations and the fees they charge for an overdraft.
There are two types of overdrafts:
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Unauthorised Overdrafts: These overdrafts are unplanned and happen when you spend more than you have in your current bank account.
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Authorised Overdrafts: These overdrafts are arranged in advance. This will include an agreement with your bank that you want an overdraft and how much you wish to borrow.
If you are debating getting an overdraft, an authorised overdraft may be a better option. Although banks can charge you an annual interest rate for both authorised and unauthorised overdrafts, if you enter an unauthorised overdraft, this can also negatively impact your credit score as it shows signs of financial struggle.
How Do I Know If An Overdraft Is Right For Me?
The most important point to keep in mind regarding overdrafts is that they are a type of loan. As a result, the bank will charge interest on the overdrafted amount. Some banks may also charge a one-time insufficient funds fee. All these added costs will need to be repaid within a week.
But how can you know if an overdraft is a suitable option for you?
When it comes to unauthorised overdrafts, these are typically not a good option, as they can result in costly charges. Entering into an unauthorised overdraft can also negatively affect your credit score.
Unauthorised overdrafts should only be used out of necessity. If you have no other options and must use an unauthorised overdraft, ensure you repay it as soon as possible to limit the financial and credit damage. Future employers will be able to see if you frequently find yourself entering into unauthorised overdrafts and may assume you have difficulty handling your finances. So, these should be avoided where possible.
On the other hand, authorised overdrafts may be a suitable option if you have automatic bill payments set up. In these circumstances, you can still ensure your bills are covered even if you don’t have sufficient funds available in your account. While you will have to pay minimal interest and fees, you can save yourself the headache of gas or electricity shut-offs and missed payment costs.
However, if you opt for authorised overdrafts, make sure you are not frivolously spending on luxury expenses. As with any other kind of short-term loan, an overdraft should only be a last-resort option for emergencies.
