Overdraft interest is calculated monthly, based on the amount that you’re borrowing. Your monthly charges may go up or down, so the costs can be hard to predict. Ultimately, the more debt you’re in the more you’ll be charged every month. Reducing your overdraft helps to save money, decreasing the monthly fees and charges.
How Are Overdraft Interest Rates Calculated?
Overdraft interest is charged according to an annual rate, called an APR. It will be calculated every month based on how far into your overdraft you are. Overdraft interest rates vary depending on who you bank with.
Read on for more details about how overdraft interest rates work.
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Overdrafts: Understanding APR
An APR is an Annual Percentage Rate. Essentially, it’s how much interest would be added to your debt if your debt stayed the same through the year.
In the UK, overdraft interest rates are usually up to 40%. This means that if you borrowed £100, you’d pay £40 in interest through the year. After spending a month with a £100 overdraft, you’d be charged roughly £3.34 in interest. That’s one-twelfth of the £40 annual interest you’d be charged.
The flat interest rate for overdrafts is relatively new, as banks used to add daily charges for using an unarranged overdraft. With this now being stopped, banks have raised their overdraft rates to counter the move, with the Financial Conduct Authority issuing a warning that they are monitoring rates to ensure they don’t become an unfair way of getting around the new laws. These new interest rates have left many customers worse off and so the FCA may crackdown soon.
Calculating Overdraft Interest Rates
Though APR alone is easy enough to understand, it’s not always helpful for predicting how much you’ll be charged. Very few people stay in the same amount of debt through the month.
You may be £100 into your overdraft at the end of the month, but it’s also very likely that your overdraft amount has been fluctuating all through the month. When you’re calculating how much interest you’ll be charged, you’ll have to consider how the amount that you owe could have gone up or down through the month.
If you started the month on £100 of debt, spent a further £400 but paid that back before the end of the month, your interest calculation would include the days that you spent in more debt.
Why Most Banks Use EAR
Most banks don’t show the percentage rate as an APR. This is because your interest rate needs to consider compound interest.
Put simply, your overdraft wouldn’t stay the same if you left it alone. If you got into £100 of debt but didn’t spend any more money, you wouldn’t be in £100 of debt at the same point next month. If you were charged £3.34 in interest after your first month, this would be added to how much you’d be in debt in the second month. Now, interest must be calculated on a debt of £103.34, rather than £100.
In month two, 40% of £103.34 is £41.34. Now, your monthly interest is £3.44 (a 10p increase on the previous month). This will be added to your overdraft debt, so you’ll start the new month with an overdraft of £106.78. And so, the cycle continues.
Through the year, even if you completely ignored it, your overdraft would continue to grow.
Banks use EAR as this takes compound interest into account. Essentially, this tells you how much you’d owe if the interest was added each month. EAR is more accurate than APR because it doesn’t base your percentage rate on just your original debt.
Banks may decide to use the APR or EAR in their calculations. When you’re planning to borrow money, it’s important to pay close attention to which calculation is used.
Different banks may offer different overdraft buffers. This is how much you’ll be allowed to borrow before the interest charges start.
A buffer allows you to make a mistake, if getting into debt wasn’t planned. If you accidentally overspent on groceries, you’d be able to clear a small debt without interest charges being added.
Usually, an overdraft buffer is around £50 in total. So, you can get up to £50 in debt without being charged for your borrowing.
If you went over your £50 buffer, that amount would stay interest free. You’d only be charged overdraft interest on borrowing over £50.
Arranged and Unarranged Overdrafts
In the past, different rates could be charged for different types of overdraft. If an overdraft was approved, or agreed in advance, it was cheaper than an overdraft that wasn‘t. It could cost more to borrow the same amount of money if your overdraft hadn’t been approved.
Since April 2020, banks are no longer allowed to charge two different rates of interest. However, lenders will still use the terms ‘arranged’ and ‘unarranged’. It’s helpful to know the difference between arranged and unarranged overdrafts, but also useful to know that the charges for both should be the same.
Arranged overdrafts are ones that have already been approved by a bank. You’ll see this listed alongside your bank balance as an available amount. You can spend this money whenever you want, as it’s already provided as credit.
An unarranged overdraft hasn’t been approved by a bank. Rather than rejecting a payment that you can’t afford, the bank may choose to allow the payment to be processed. Now, you’re in an unarranged overdraft.
Unarranged overdrafts go above and beyond your usual overdraft limit, whether you typically have no overdraft available or you’ve spent beyond the limit that’s agreed. You can have a £500 arranged overdraft but still go into an unarranged overdraft by spending an extra £20.
If your overdraft is approved, you won’t hit a wall at the checkout. The money is available to spend as soon as you want it. If you don’t have an arranged overdraft, you’ll be taking a chance. You may have your transaction approved and get a temporary overdraft, but could just as easily find that it’s rejected and the bank won’t let you borrow any money.
Getting Out of Your Overdraft
If you’re using an overdraft, you’ll need to consider the cost of overdraft interest. As this is added monthly it increases your debt, so will need to be factored into any repayment plan.
To get out of your overdraft, you’ll need to pay in more than you’re being charged each month. If your overdraft interest is roughly £16 on £500 of borrowing, you’ll have to spend around £20 less that month just to make a small dent in your overdraft. As you can imagine, it could take a long time to clear your debt completely. Fortunately, as your overdraft decreases so will the interest you’re charged.
Are Overdrafts a Cheap Form of Borrowing?
As it’s relatively easy to get and use an overdraft, many people mistakenly believe that overdrafts are a cheaper debt. In fact, overdrafts can become very expensive and may even cost more than payday loans.
Where payday loans are a short-term debt, often only charging interest for a month or two until they’re paid off, overdrafts can run indefinitely and result in higher charges overall.
If you get a little too comfortable with your overdraft, it’s easy to get into a debt spiral. You may struggle to get out of the overdraft and back into a positive balance. If this happens, the overdraft interest can quickly start to mount up.
Quick Overdraft FAQs
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