6 things you need to know about overdrafts

By Marianne Curphey

Overdrawing your debit card and racking up overdraft fees is easier than you think.

While some debit cards require that enough money is in the account to complete a transaction, others don't, according to public advice service Directgov. Without the proper protections in place, overdrawing your account can happen without your knowledge or approval.

So what happens when you overdraw? How much will it cost you in penalty fees? The answers are a mystery to many consumers, according to consumer advocacy group Which?. Which? tasked a group of volunteers to calculate the overdraft charges they would incur at several major banks, based on a mock bank statement. Working together, the group got just seven out of 48 calculations correct. overdraft

Even worse, according to Which?, many major banks use a bewildering daily overdraft fee structure that could cost consumers the equivalent of a 2,000% annual percentage rate (APR).

Clearly, overdrafts are both complicated and expensive. To stay out of the red and avoid drowning in fees, know these six vital facts about overdrafts.

1. Not all overdrafts are the same
Overdrafts come in two general flavours - "authorised" and "unauthorised."

An authorised overdraft is an "agreed loan with your bank," explains independent financial adviser Philip Pearson of P&P Invest in Southampton.  "A credit limit is set and you are then able to use this at your discretion in operating the account."

In other words, an authorised overdraft is a safety net that allows you to borrow money to help you through a short-term cash flow problem -- when you are waiting to be paid, for example. It's called an authorised overdraft because your bank has officially agreed to it.

Some bank accounts have a free overdraft facility built in. If yours doesn't, you'll have to ask your bank to add it. You will probably pay an arrangement fee - and you'll have to repay the overdraft amount plus interest.

An unauthorised overdraft, on the other hand, occurs when you go into the red without first making an arrangement with your bank. If possible, you should never do this, as the charges incurred for unauthorised credit are much higher than those for authorised overdrafts. In addition to interest charges, you'll also likely end up paying hefty penalty fees.

2. To get an overdraft, you must be in good standing with your bank
Pearson says that your bank will look at your financial record and possibly your credit rating to establish the risk of offering you an overdraft. If you have a good record with the bank (you rarely approach a zero balance and deposit money regularly), getting one will be easier, according to Directgov. You will normally be given an overdraft for a set time, often a year, and you will be able to renew it if you stick to the terms.

3. Costs vary greatly between banks
The cost of an overdraft differs among the banks. Which? found that some banks charged twice as much as others for overdrafts of the same amount.

"It makes sense to shop around," Pearson says.  "Some banks provide a limited overdraft of up to £500 as a feature of the current account."

Some banks may charge extra to set up an authorised overdraft and charge each time you want the overdraft cushion increased. If your bank account history is poor, you may be charged a higher interest rate than is advertised

4. You must be aware of your overdraft limit
Read the small print whenever entering into an authorised overdraft agreement with a bank.

The total amount you can borrow is known as your "overdraft limit." Just as with a credit limit on a credit card, it is vital you don't exceed it. The transaction may be denied. Or, it will essentially transform into an unauthorised overdraft - and cost you extra fees and interest.

5. An overdraft is not guaranteed
A bank can revoke an existing overdraft at its discretion. For example, it may send you a letter saying that your overdraft agreement ends on a specific date and that you will be required to reapply for a new agreement. If your finances have taken a dive since you formed the last agreement, getting a new overdraft agreement may be difficult.

6. Overdrafts are an expensive way to borrow
Even authorised overdrafts are expensive -- the average overdraft interest rate in January was 19.51%, according to the Bank of England.

Just as with credit cards and payday loans, the convenience of spending more money than you have comes at a cost. Even if you use your overdraft wisely, you'll end up paying set-up fees and interest. If you don't (and exceed your limit), you'll end up paying additional penalty fees as well.

So be sure to keep an eye on your account balances. If they're approaching zero, slow down your spending instead of relying on your overdraft agreement to break your fall. That way, you'll reserve overdrafts for what they were intended - for emergencies.

See related: Being too credit-shy can backfire, Is payment protection insurance right for you?

Published: 5 April 2012