What Is a Bank Overdraft?

A bank overdraft is a type of short-term borrowing that allows you to spend more money than you currently have in your bank account, up to an agreed limit. When your balance falls below zero, you are using an overdraft. The bank provides the additional funds, which are then repaid when money is paid into the account.

Key features include:

• Flexible borrowing: You only use the amount you need.
• Revolving facility: Payments into the account automatically reduce the amount borrowed.
• Short-term finance: Overdrafts are generally designed for temporary cash-flow needs.
• Interest on the amount used: Interest is normally charged only on the amount you have borrowed.
• Agreed limit: The bank sets the maximum amount you can borrow.

Arranged vs Unarranged Overdrafts

There are two main types of overdraft, and their terms can differ significantly.

What Is an Arranged Overdraft?

An arranged overdraft is agreed with your bank in advance. The bank provides a specific borrowing limit and sets the applicable interest rate, usually shown as an EAR (Equivalent Annual Rate).

Following the FCA’s overdraft reforms, personal overdraft pricing is generally presented using a single interest rate rather than separate daily or monthly overdraft fees.

What Is an Unarranged Overdraft?

An unarranged overdraft occurs when you spend beyond your agreed overdraft limit or spend without having an arranged facility. The bank may either allow the transaction or decline it.

Banks generally no longer apply higher overdraft charges simply because an overdraft is unarranged. However, transactions that would take an account beyond its available funds may still be refused.

How Is Overdraft Interest Calculated?

Overdraft interest is generally calculated according to the amount borrowed, the applicable interest rate and the number of days the account remains overdrawn.

Example: If you borrow £500 for 10 days at an EAR of 39.9%, the interest would be approximately £5.47 for those 10 days.

The longer you remain overdrawn, or the larger the balance becomes, the more interest you are likely to pay.

Personal Overdraft Rules in the UK

The FCA introduced major changes to personal overdrafts in 2020. These included:

• Personal overdraft pricing being expressed through a single interest rate.
• Banks being prevented from charging more for unarranged overdrafts than arranged overdrafts.
• Greater transparency around overdraft interest rates.
• Customers being able to opt out of certain unarranged overdraft facilities.

These changes were introduced following concerns about the cost of overdraft borrowing and the impact of high charges on consumers.

Business Overdraft Facilities

A business overdraft can provide a flexible source of working capital. It can help a business manage temporary gaps between paying suppliers and receiving money from customers.

Business overdrafts may include:

• Annual reviews: The bank may regularly reassess the facility.
• Security requirements: Larger facilities may require security or a personal guarantee.
• Variable interest rates: Rates may be linked to the Bank of England base rate plus a lender’s margin.
• Arrangement or renewal fees: Some banks charge fees for maintaining the facility.
• Facility agreements: The borrowing limit, interest rate and other conditions are normally set out in a facility letter.

Business Overdraft Costs

The cost of a business overdraft depends on the lender, facility size, interest rate and how long the money remains borrowed.

For example, if a business has a £50,000 overdraft and uses the entire facility for six months at an annual interest rate of 7.5%, the approximate interest cost would be £1,875.

Actual costs can differ depending on the terms agreed with the bank.

Tax Treatment of Overdraft Interest for Businesses

Interest on an overdraft used for genuine business purposes can generally be treated as a business financing expense, subject to the applicable tax rules.

For example:

• Limited companies: Qualifying business overdraft interest may be deductible when calculating taxable profits.
• Sole traders: Qualifying interest on business borrowing may be treated as an allowable business expense.
• Mixed-use borrowing: Where an overdraft is used for both business and personal spending, only the qualifying business proportion may be deductible.
• Personal overdraft: Interest on borrowing for personal expenditure is generally not an allowable personal tax deduction.

Overdrafts and Credit Ratings

Using an overdraft can affect how lenders view your financial position.

An arranged facility normally appears as available credit, while frequent or heavy use may suggest that you rely on borrowing to manage regular expenses. Regularly reaching the overdraft limit can also concern lenders.

Mortgage providers may review bank statements when assessing an application, so persistent overdraft use could affect their assessment of your affordability and financial management.

Business borrowing can also be considered by commercial lenders when assessing a company’s creditworthiness.

Alternatives to Overdrafts for UK Businesses

Businesses have several alternatives when they need additional working capital:

• Invoice finance: Allows businesses to access funds against eligible unpaid invoices.
• Business credit cards: Useful for short-term expenditure when the balance can be managed effectively.
• Asset finance: Can spread the cost of equipment while preserving cash.
• Revolving credit facilities: Provide flexible borrowing and may be suitable for larger funding requirements.
• Business loans: Can be more appropriate where a business needs a fixed amount of finance over a defined period.

Frequently Asked Questions About Bank Overdrafts

Does an Overdraft Affect My Credit Score in the UK?

Yes. Regularly relying heavily on an overdraft, particularly when you frequently approach or reach the agreed limit, can potentially make you appear more financially dependent on borrowing to lenders.

Using an arranged overdraft responsibly and staying within the agreed limit is generally less concerning than repeatedly exceeding available borrowing.

Can a Bank Remove My Overdraft Facility?

Yes. Banks can review overdraft facilities and may reduce or withdraw them, subject to the terms of the account and applicable notice requirements.

If you rely heavily on an overdraft, losing the facility could create cash-flow difficulties, so it is sensible to maintain alternative funds where possible.

Is Overdraft Interest Tax-Deductible for Self-Employed People?

Interest on an overdraft used for genuine business purposes may be an allowable expense for a sole trader or partnership, subject to the relevant tax rules.

Where the facility is used for both personal and business spending, the business-use element needs to be considered separately.

What Is the Difference Between an Overdraft and a Loan?

An overdraft is a flexible, revolving form of borrowing. You can borrow, repay and borrow again within the agreed limit, with interest generally based on the amount actually used.

A loan normally provides a fixed amount that is repaid through agreed instalments over a specified period.

In general, a loan can be more suitable for larger, long-term borrowing, while an overdraft can be useful for short-term working-capital requirements.