The basics on being overdrawn

An overdraft is an agreed cash-borrowing limit arranged with your bank. It gives you a flexible way of managing your cash flow and can provide you with short-term funds if you don't have enough money, but it's not a loan.

Overdrafts can help you if, for example, you have an urgent phone bill to pay today, but the funds won't go into your account until next week. The overdraft enables you to pay off the bill, without having the appropriate amount of money in your account.

How do I arrange an overdraft?

As with all forms of credit, you must be over 18 years of age before you can apply for an overdraft. You should talk to someone at your local bank branch. Some banks or building societies can arrange an overdraft through their telephone or internet banking service. However, not all bank accounts offer overdraft facilities.

It is crucial to avoid going overdrawn if you haven't arranged it with your bank, or if you are about to go over your overdraft limit. If you do not arrange to have an overdraft or an extension before the money leaves your account, you may be charged steep penalty fees as well as a much higher rate of interest. The bank could also continue to charge you extra fees every time it sends you a letter telling you you are overdrawn. The fines could add up to hundreds of pounds.

What are the benefits of an overdraft?

Overdrafts are ideal for borrowing money you know will be replaced quickly when your salary or regular funds are paid into your account.

However, it doesn't work out as good value if you are borrowing thousands of pounds in this way and never clearing your debts.

What are the disadvantages

• Some banks charge a fee for setting up an overdraft
• Overdraft facilities can be withdrawn or reduced by banks or building societies at any time
• If you go overdrawn before agreeing a limit with your bank you will have to pay additional high charges
• If you go overdrawn above the limit agreed with your bank you will also face higher charges
• If you are overdrawn and decide to transfer your bank account you must pay off your overdraft first because you are, in effect, in debt to the bank.

Free or cheap overdrafts

It's worth checking if your bank has a buffer zone that allows you to go slightly overdrawn each month without incurring the high charges usually associated with unauthorised overdrafts. There may be a small annual charge for this facility. Some banks and building societies also offer preferential terms to students, which could mean that overdrafts attract reduced interest rates or are free up to a certain amount.

Unfair charges?

If you go over your agreed overdraft limit, you may be charged a 'default charge', which can be anything from £20 to £40 for a single charge. Many people believe this is a rip-off. 

There have been so many complaints about unfair overdraft charges that the Office of Fair Trading (OFT) took a test case through the courts in an attempt to change things for consumers. Despite a lengthy legal battle the OFT finally lost to the banks on a technicality.

It is possible that the watchdog will mount a new challenge in the future. But for now, reclaiming bank charges looks set to be as tricky as ever.

However, if you are in hardship and you have outstanding overdraft charges, you can claim against your bank. See MoneySavingExpert's guide to Bank Charges for people in Hardship. The law is different in Scotland and, as a result, some Sheriff courts are allowing cases to be heard.

Thanks to the Citizens Advice Bureau for help with this article.

Updated: 09/01/2013