Overdrafts explained

Resources · Cards, loans and credit · 5 min read Starting out

Key points

• An overdraft lets you spend more than is in your account, up to a limit.
• Arranged overdrafts are agreed in advance. Unarranged ones happen when you go over.
• You can pay interest, fees or both, and fees can be huge next to small amounts.
• Overdrafts are built for short gaps. Plenty of people end up in one every month.

What an overdraft is

An overdraft is borrowing that’s attached to your everyday bank account. Spend more than you’ve got and the balance drops below zero. The bank covers the difference, and you owe it back.

There’s usually no set repayment schedule. Whatever comes into the account next, like your pay, goes towards clearing it automatically. That sounds convenient. It’s also why overdrafts are so easy to slip into without noticing.

Arranged and unarranged overdrafts

With an arranged (or authorised) overdraft, you and the bank agree a limit in advance. Say $500. You can go below zero up to that limit, and you’re charged interest, a fee, or both on whatever you use.

An unarranged (or unauthorised) overdraft is what happens when you go below zero with no agreed limit, or blow past the one you have. The bank might let the payment through and charge you. Or it might refuse it. A refused payment can cost you twice: a fee from the bank, and another from whoever you were trying to pay.

Names, rules and costs differ a lot between countries and banks. Some places regulate how overdraft charges are set. Others leave it mostly to each bank. Your account terms spell out what applies to you, so read them.

How overdrafts are charged

Most overdraft costs come in one of three shapes.

Interest is a rate charged on the amount you’re overdrawn, often worked out daily. Flat fees are a fixed charge each time you go overdrawn, or each time a payment goes through while you’re below zero. And some accounts charge a daily or monthly fee for every day or month you stay under.

Some accounts mix more than one. Some accounts don’t charge on very small amounts.

Two worked examples

Interest charged daily

Assumptions:

• Overdrawn by $500
• Interest rate: 20% a year, charged daily (daily rate = 20% ÷ 365)
• Overdrawn for 20 days
• No other fees

Interest: $500 × 20% ÷ 365 × 20 = $5.48.

For a short gap, that’s a fairly modest cost. The same maths works in any currency.

A flat fee on a small amount

Now picture an account that charges a flat $35 fee when you go overdrawn, and no interest. You buy something for $20 and it takes you $20 below zero.

The fee is $35. That’s 175% of the $20 you borrowed.

Then two more small purchases go through while you’re still overdrawn, each with the same fee. Now it’s $105 in fees on what might be less than $60 of spending.

These figures are just an illustration. Your bank may charge more or less. But the pattern holds: flat fees hit small amounts hardest.

The “permanent overdraft” pattern

An overdraft is meant for short gaps, like a bill landing a few days before payday. Here’s how it often goes instead:

1. Pay comes in and clears the overdraft.
2. Bills and spending push the account below zero again before the next payday.
3. Charges get added to what you owe, so the gap grows a little every month.

If you’re overdrawn for part of every month, your overdraft has turned into a long-term loan. Often an expensive one. It also makes it hard to see how much money you actually have.

Ways people reduce overdraft costs

There’s no one answer here, and each approach has trade-offs. What suits you depends on how your income arrives and what your regular bills look like.

Start by watching your balance closely, including the payments that come out automatically (see how to read your bank statement). Going below zero shouldn’t be a surprise. If your bank offers balance alerts, switch them on.

Look at the timing of payments you control. Transfers to savings, for example, can go out just after payday rather than just before.

A small buffer in the account helps a lot, even a modest one, because small gaps stop triggering fees. Some people chip away at the overdraft gradually by leaving a little more in the account each month. And charges differ between account types, so it’s worth comparing what other accounts cost.

If you’re leaning on an overdraft every month just to cover essentials, free debt help is confidential and can help you look at the bigger picture.

Common questions

How much does an overdraft cost?

It depends on the account. You might pay interest, flat fees, daily or monthly fees, or a mix. Flat fees hit small amounts hardest.

What is the difference between an arranged and unarranged overdraft?

An arranged overdraft has a limit agreed in advance. An unarranged one happens when you go below zero without an agreed limit, or past your limit. That can mean extra charges or refused payments.

What if I’m in my overdraft every month?

Then it’s become a long-term loan, and often a costly one. Some people build a small buffer, or pay it down gradually by leaving a little more in the account each month.

Try it

Put an overdraft’s interest and fees into the true cost calculator to see what it costs you over time. The budget calculator can help you spot where the month runs short.

General information only, not financial advice. Your situation is your own.