When your bank account balance goes below zero, you are “in overdraft”. The bank is now lending you money, and like a debt owed on a credit card you must pay them back.
What happens if you don't pay your overdraft
First of all, it's okay to be in your overdraft. It’s actually quite common. More than 26 million Brits use their overdraft every year.
But you don’t want to stay in overdraft for long or fall into it often, because banks charge you “overdraft fees” for borrowing their money. Overdraft fees are big business for banks: £2.4 billion in 2017 alone.
Fees vary. They tend to be lower with an Arranged overdraft – meaning you as the account holders agreed to an interest free overdraft limit with your bank in advance. If it is unarranged, fees can be harsher.
Helpfully, as of earlier this year, the Financial Conduct Authority has said that banks can’t charge you for going over your overdraft limit. They also must charge a single overdraft interest rate (instead of fixed daily or monthly fees.)
As for your credit score, dipping in and out of overdraft won’t impact it. But credit agencies will see if you stay in overdraft and don’t repay the bank for long periods. This will sound some alarms.
How to reduce my overdraft
If you are in overdraft, don't stress. Instead, make a plan to get out and stay out.
Step 1: Figure out how much your overdraft is costing you
An overdraft is an expensive way to borrow money. The fees add up fast. A few pence and pounds here and there may not seem like such a big deal, but they can really hurt.
If you find yourself in overdraft the first thing you should do is get visibility of the problem. Find out how much you are being charged and when. Check that you are within your limit of an arranged overdraft, and get on the phone with the bank ASAP if you are in an unarranged overdraft. They may be able to set one up for you on the phone.
For full visibility, you can use an app like Money Dashboard — which uses open banking technology to securely connect all of your accounts. This will help you to see how much money you pay in overdraft fees month over month.
Step 2: Save and budget your way out.
If you are within your arranged overdraft, you can calmly work your way out. If you are in an unarranged overdraft, consider the matter urgent.
Slow and steady approach for reducing and getting out of overdraft:
If you have time to get out of an arranged overdraft over months, even years if you are in very deep, your issue is likely one of budgeting and saving.
As before, the first step is to get a consolidated view on your spending, bills and accounts all in one place. Having it all laid out and your spending categorised is the best way to see where money is being wasted and where you can pull back. It is also the foundation for creating a budget. You can read how Guy used this approach to work his way out of overdraft debt.
Month over month reduced spending will help to clear your overdraft and bring down overdraft charges. It’s recommended to set a target for yourself (“I’ll be out of my overdraft in 6 months”) and do some quick maths to determine how much less you need to spend each month to do so.
Quick exit approach
Don’t waste a moment in your unarranged overdraft if you have a means of getting out. Here are the best ways to avoid overdraft fees:
- Transfer funds. If you have any savings or money you can access, this is a great time to use it. Quickly transfer money to the appropriate account to clear or reduce debts. It’s always best to have a float to avoid an unarranged overdraft, so you can quickly transfer money if, for example, you see a big bill coming up.
- Call your bank. Let them know if you're in a bind. And ask them: Can overdraft fees be waived? Many have ways to assist you. It never hurts to ask.
- Switch to a 0% interest account or credit card. By moving your overdraft balance to a 0% interest credit card, you effectively remove your overdraft from your bank account. The debt now sits in a new account, which you can pay back over a set period with no interest fees. Although be sure to pay it all back before the 0% interest deal expires. You can read more about 0% interest cards and how to get one here.
- Prioritise your debts. Different accounts and cards charge different interest rates on unpaid debt. Pay your most expensive ones off first, while making at least minimum payments on other debts so you aren’t hit with heavy fines from all fronts.
- Make a budget. Debt management is important for you now and going forward. As above, you want to make a budget plan to reduce your spending and building up savings, so falling into overdraft will be a thing of the past. Learn more about how to make a budget here.