Your Guide To How Overdrafts Work
An overdraft is essentially a type of short term credit facility that banks offer jointly with your current bank account. It can be thought of as a loan, and its extent depends on your overall credit score. In simple terms, when you enter an overdraft agreement with your bank, your bank essentially allows you to spend more money than what you may have in your bank account, and they essentially allow you to take a loan. While some banks operate an automated overdraft facility with no need to apply for it separately on your part, others require you to apply for an overdraft facility specifically. In terms of financial management and managing your personal expenses, one should think of an overdraft as a simple short-term form of credit that they can use in an emergency, rather than thinking of it as an allowance that they can use on a regular or monthly basis.
What are the types of overdraft?
There essentially exist two types of overdrafts: an arranged overdraft or arranged OD, and an unarranged overdraft or unarranged OD. The former refers to a situation when you have entered an agreement with your bank before overdrawing money from your account. Whereas, the latter refers to when you overdraw your bank account without arranging such a facility with your bank prior and is known as unarranged OD usage. A situation in which you may have an OD facility in place, but you still end up drawing more than your OD facility allows is still known as unarranged OD.
What is the problem with an unarranged overdraft?
The problem with an unarranged OD is that banks charge you on a daily, weekly or monthly basis for it until you settle the amount that you have overdrawn in your account. Not only can these charges add up to become a significant cost, they can also badly affect your credit score.
While certain banks notify you when you attempt to take out more money than what you have in your account by a notice or a text message, certain banks don’t notify you and you would be able to withdraw money regardless of your account balance. This is especially true when one is dealing with a standing order or a direct debit.
How can one avoid an unarranged overdraft?
If you feel that you need to overdraw money from your bank account in a certain month due to exceeding finances, or if you feel you may truly make a mistake and overdraw money, you should be safe and arrange for an OD facility with your bank if you don’t automatically have one in place. If you already have an OD facility and end up overdrawing from its credit limit, speak to your bank to extend the amount that you are allowed to overdraw.
Other than the above, you should try creating a monthly budget for yourself that you follow religiously to ensure that you don’t need to overdraw money from your bank account at all. You should also track your monthly expenses. It is recommended that you check your account balance regularly as well.
*This is a collaborative post.