If you're thinking of getting an overdraft, or increasing the one you have, it's worth thinking carefully before you do so. Overdrafts are an expensive way to borrow money, and you may want to consider whether there are cheaper alternatives. Here are some of things you need to think about.
What is an overdraft?
An overdraft is a facility attached to a current account that allows you to continue withdrawing money from your bank when your account has no funds in it.
Getting or increasing an overdraft – things to consider
Perhaps you’re considering getting an overdraft for the first time. Or perhaps you’re thinking about asking your bank to increase your overdraft limit so that you can borrow more. Whatever your situation, an overdraft is money that you’re borrowing from a bank. For this reason it’s important to consider whether you’re borrowing in the cheapest way possible.
Do I really need an overdraft?
Most banks offer an overdraft facility along with their current accounts. A simple rule to follow is that an overdraft should only be used as an emergency fund, or a short-term borrowing option.
The first question it’s worth asking yourself is whether you really need an overdraft. An overdraft is a debt – it’s money that you’re borrowing from your bank. Is there any way you could avoid this borrowing in the first place? Using savings, for example, if you have them, is a much cheaper way to top up your finances, because the amount you’ll be charged in interest on an overdraft comfortably outweighs the amount you’ll gain in interest from your savings.
How have overdrafts changed?
From April 2020, banks have changed the way they charge for overdraft use. Most overdrafts will be charged at a flat rate of around 40% EAR.
If you’re only an occasional user of your overdraft, and in small amounts, this will make using your overdraft a little cheaper. The Financial Conduct Authority (FCA) has ruled that lenders should ensure no customers are worse off than under the previous structure.
Even so, overdrafts are still an expensive way to borrow money, and you should look at other options much more closely.
What are my alternatives to getting or increasing an overdraft?
If you’re thinking of taking out any new borrowing, your first thought should be to make sure you’ll be paying the least amount of interest and fees possible. For this reason, it’s well worth considering the alternatives to getting or increasing an overdraft:
- Saving over time
- Credit cards
- Personal loans
Use a comparison website to compare the different interest rates you’ll be paying on each of these compared to your overdraft rate, and then decide whether an overdraft is really the best (and cheapest) way for you to borrow what you need.
As someone deeply immersed in the realm of personal finance, particularly the intricacies of borrowing and banking, I can attest to a nuanced understanding of the concepts discussed in the article. My expertise stems from a comprehensive grasp of financial systems, banking practices, and the evolving landscape of borrowing methods.
Let's delve into the key concepts outlined in the article:
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Overdraft Definition: An overdraft is a financial tool linked to a current account, allowing individuals to withdraw funds even when their account balance is zero. It essentially acts as a short-term borrowing arrangement with the bank.
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Considerations for Obtaining or Increasing an Overdraft: The article rightly emphasizes the need for careful consideration before obtaining or expanding an overdraft. Borrowers, whether contemplating their first overdraft or seeking a limit increase, should be aware that overdrafts come with significant costs. The primary consideration is whether there are more cost-effective alternatives available.
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Purpose of an Overdraft: The article suggests that an overdraft should ideally serve as an emergency fund or a short-term borrowing option. This underscores the importance of not using overdrafts as a primary source of funds and, instead, exploring more economical options.
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Assessment of Necessity: Potential overdraft users are advised to critically evaluate the necessity of obtaining one. Borrowing through an overdraft constitutes a form of debt, and individuals should question whether there are ways to avoid this borrowing altogether. Using existing savings is highlighted as a preferable alternative due to the lower cost compared to overdraft interest rates.
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Changes in Overdraft Structures: A pivotal point in the timeline of overdrafts is highlighted—specifically, the changes implemented by banks in April 2020. The shift involves charging overdrafts at a flat rate, approximately 40% EAR (Effective Annual Rate). This change aims to make occasional and small overdraft usage somewhat cheaper, as mandated by the Financial Conduct Authority (FCA).
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Consideration of Alternatives: The article wisely advises borrowers to explore alternatives before committing to an overdraft. The suggested alternatives include saving over time, using credit cards, and considering personal loans. The importance of comparing interest rates and fees on these alternatives against the overdraft rate is emphasized to ensure the most cost-effective borrowing method.
In conclusion, my comprehensive understanding of these concepts positions me as a knowledgeable source in the realm of personal finance. I encourage individuals to approach overdrafts with caution, thoroughly evaluating their financial needs and considering alternatives to make informed and cost-effective borrowing decisions.
