For many of us, getting an overdraft is the first step on our journey with borrowing. In the UK, it’s common to be offered an arranged overdraft when you apply for a current account. And if there’s an introductory offer, or you’re a student, you might start off borrowing interest-free. Way-hey, free money! Right…? Not quite.
Before you take your shiny new debit card for a spin make sure you know the facts. Is an overdraft a good idea for you? Does going into your overdraft affect your credit score? What does it mean to manage your overdraft responsibly? And why does having a good credit score matter, anyway?
Whether you’re totally new to overdrafts or you’ve had one for a while, we’ll help you get to grips with everything you need to know. So sit back, relax and let Loqbox do the rest. You’ll be an overdraft oracle before you know it!
What is an overdraft?
The clue is in the name
You go into your overdraft when you’ve withdrawn, or spent, more money than you have in your bank account. This usually happens when you go over your budget, or you face unexpected costs which are over the amount you’d usually spend in a month.
The bank lends you money to cover these payments, meaning they will go through even though you don’t have the cash to cover them.
Let’s get one thing clear from the start — overdrafts are a type of debt
An arranged overdraft is a line of credit that’s advertised as a buffer. Some extra cash to help you when there’s too much month left at the end of the money. But it’s important to remember that using your overdraft means you’re going into debt. And that’s a fact that’s tempting to ignore.
Overdrafts might seem like less of a commitment than a credit card or loan. But how you manage your overdraft might show on your credit report. Just like any form of borrowing, your overdraft could affect your credit score (both positively and negatively).
Why is my credit score important?
You want to get the credit you deserve
When you borrow money, lenders report the way you manage it to the Credit Reference Agencies (CRAs). In the UK, the three main CRAs are Equifax, Experian and TransUnion. The record they keep is called your credit history.
Lenders use your credit history to make decisions about whether to lend you money and what rates to give you. (That includes things like being offered an overdraft, a loan, a mortgage, phone contact or car finance.)
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You can check your credit score to get an idea of how lenders might view you. It’s a number that helps you understand how your credit history is going. Improving your credit score could save you £1,000s on the things that matter to you.
Does having an overdraft affect your credit score?
It depends on what you mean by having...
People mean different things when they talk about having an overdraft. We think it’s helpful to separate having an overdraft agreement with your bank from going into your overdraft.
Simply having an overdraft available – but not using it – means it’s unlikely to be reported to the Credit Reference Agencies. In the UK, banks only report the way you manage your borrowing once a month. So if your overdraft isn’t active (being used) on that day, it won’t affect your credit score positively or negatively.
When you go into your overdraft, it could show on your credit report. That could improve your credit score if you’re using your overdraft responsibly (i.e paying it off regularly, staying within the agreed limit and not going over that limit to create an unauthorised overdraft). But not keeping on top of your spending or going over the limit could damage your credit score.
Applying for an overdraft will show on your credit report
Applying for an overdraft will show on your credit report. Your bank will do something called a hard credit check. That means they check your credit report and leave a record of your application.
Bear in mind that applying for a higher overdraft limit will also show as a hard check. The bank will need to check if you can afford to borrow more money.
Applying for lots of different types of credit in a short period might suggest that you’re struggling to keep on top of your spending. And that could lower your credit score.
Your overdraft appears on your credit history when you use it
Banks and building societies report to the CRAs once a month. That means that your overdraft will only be reported if you’re using it. So if it’s active, lenders will be able to see your overdraft limit (the amount the bank has agreed to lend you), how much you’re spending and when and whether you’re making repayments.
Yes, a student overdraft does affect your credit score (if you’re using it)
If you’re a student, you might find that going into your overdraft is normalised. Most students will be offered an interest-free overdraft with their student bank account. That means that for a set time, you won’t be charged for borrowing money. But an interest-free student overdraft is still an overdraft.
And bear in mind that you’re likely to be charged interest on your overdraft balance after you graduate. If you get into the habit of going into your overdraft every month, you could end up in a borrowing cycle.
So remember that an overdraft isn’t designed to be used in full every month. It’s important to pay off your balance regularly. This avoids expensive charges in the long run and protects your credit score.
This doesn’t mean that having an overdraft is a bad idea.
We want you to make informed decisions about borrowing money. And overdrafts are no exception. But we’re not saying that having an overdraft is a bad idea. There are some benefits, but it’s important to understand how going into your overdraft could impact you.
What’s the difference between an arranged and an unarranged overdraft?
Overdrafts are one of the most expensive forms of borrowing. But that doesn’t necessarily mean they’re not worth having.
An authorised overdraft can be a good buffer
An authorised overdraft (also called an arranged overdraft) is an agreement with your bank. They agree to give you a set amount of money as a buffer. It can be a good safety net to help with unexpected costs or emergencies.
Unlike a loan, an arranged overdraft won’t show as a positive balance in your bank account. So if you use £500 of your overdraft, your balance will show as -£500. Some people call this negative balance “going into the red.”
Having an overdraft could improve your credit score
Having an overdraft available could improve your credit score. That’s because lenders like to see that you have access to credit that you aren’t using. This is called having a low credit utilisation.
That shows them that you’re in control of your spending and that you have money available as a backup. Having an overdraft available could allow you to make repayments on your other borrowing even if you faced unexpected costs.
Make sure you read the terms and conditions
If you have an arranged overdraft, it’s important to read your bank’s terms and conditions. They’ll usually agree on an amount to lend you, and tell you how much you’ll be charged for going into your overdraft balance.
Your overdraft limit is the amount of money your bank is willing to lend you. Using more of your overdraft than you have available, or making late repayments, could damage your credit report.
Going into an unarranged (unauthorised) overdraft could damage your credit score
Borrowing something without asking is usually a bit of a risk. (And going into an unarranged overdraft is a bit like wearing your friend’s favourite jumper without getting their permission first.)
Your bank might allow payments to go through even if you don’t have the money to cover them. But they’ll usually charge you more for this service than they would for an arranged overdraft.
Your bank should contact you to let you know when you’ve gone into an unauthorised overdraft. (This is a bit like your friend noticing you wearing that jumper at the pub and asking for it back.) And they’ll usually set out some terms for getting the money back.
If you’re able to pay off the balance quickly — usually on the same day — you might avoid damaging your credit score. But if you can’t pay the money back, the bank is likely to report your unarranged overdraft to the Credit Reference Agencies.
Depending on how long you take to pay off your unarranged overdraft, it could show on your credit report as a missed payment. That’s best avoided because missed payments can affect your credit score for up to six years.
To avoid nasty surprises like that, it might be worth having an arranged overdraft in place.
Does paying off your overdraft improve your credit score?
Paying off your overdraft regularly could improve your credit score
Going into your overdraft from time to time could actually improve your credit score.
Using some of your overdraft balance and paying it off regularly could show lenders that you’re in control of your borrowing. But bear in mind that keeping a negative balance from month to month is likely to cost you money in the long run.
Be careful if you’re using your overdraft every month
If you have an arranged overdraft, it’s important to avoid going into your overdraft every month. This could show lenders that you’re not in control of your spending.
If you’re in your overdraft on payday, or you’re regularly using your overdraft to pay your rent or bills, it’s probably time to make a plan.
Work out how much of your overdraft you can pay off each month. You might have to cut back on non-essential spending like your streaming subscriptions or that new pair of headphones.
If you’re not able to make the budget work, talk to your bank. They should be able to help you make a plan for paying off your overdraft. Or you can find more help from organisations like MoneyHelper or StepChange.
Think twice before you remove your overdraft
It’s far better to pay off your overdraft than to remove your overdraft. That’s because having an overdraft available increases your overall available credit. And that could help you avoid missing payments for bills or other borrowing, which could damage your credit score.
But if you struggle to avoid the temptation of going into your overdraft, it might be worth reducing your overdraft limit or using a separate account for everyday spending.
What are the alternatives to having an overdraft?
It’s a good idea to consider your options when deciding whether to borrow money. Remember that an overdraft is a buffer. So if you need to borrow money for something specific — like a mobile phone or a big purchase — there might be cheaper options available.
Write a budget
When you borrow money, you’re really borrowing money from your future self. That’s because you will eventually have to pay it back. So if you find yourself sliding into your overdraft regularly, it might be time to make a budget.
0% credit cards might be better for purchases
If you’re borrowing money to buy something, a 0% purchase credit card could be a good option. These cards give you an introductory rate of 0%. If you choose this option, make sure you make a plan to pay off the debt in the interest-free period.
And remember, there are other ways to build your credit score
If your main motivation for getting an overdraft is to build your credit score, we have some news for you!
Want to know more about credit scores?
If you want to know more about credit scores, read our blog What is a credit score? How is it calculated and what affects it?