Why is an overdraft not seen as a debt?

by StepChange Debt Charity on 05 May 2012  |  1 comment
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An overdraft is not always seen as a sign of money troubles. It should be!

Every day we speak with hundreds of people who find themselves in debt. While some have loans, or credit or store cards, many more have an overdraft debt they can’t service. But strangely the perception of an overdraft is different to a loan. Why is this when they can all lead to the same debt problems?

As you know, an overdraft is an agreement with your bank to loan you a certain amount of money that’s levied against your current account, with a more open-ended payment date.

That means that overdrafts can be cleared the next day or years later. Debt collectors aren’t going to calling at your house if you stay within the agreed limits, even if you don’t pay any of it off.

Overdraft limits

But it’s still a debt owed to a bank, and the ongoing charges can still mount up, meaning less and less of your pay cheque actually goes in your pocket.

While a loan has an agreement that sets out the terms and payment dates, this isn’t as clear with an overdraft, so the charges aren’t always budgeted for as part of the monthly expenditure.

All this means that after a while an overdraft limit can be seen as the new baseline for your account. Having an overdraft of £1,000 becomes the new £0.

This reliance on an overdraft can lead to massive issues later on. If the bank realises that you’re constantly relying on the overdraft, they’re within their rights to withdraw it. Unlike some other debts, overdrafts are “payable on demand”.

Overdrafts: the silent debt

Typical interest rates on overdrafts have risen in last few years, as the base rate has stayed historically low. In 2011 the overdraft interest rate reached 19.5% (PDF, page 37).

While this isn’t huge in itself – payday loan rates are far higher – the semi-permanence of an overdraft on a bank account means that the ongoing fees and charges can outweigh the costs of any other type of borrowing.

In comparison the average interest rate of a £5,000 loan is 16%, while the interest rate of a £10,000 loan is 9%.Even credit card interest rates are lower, at an average of 17.3%.

Having an overdraft that you can’t service month after month means that your spending power is slowly eroded, with little fall back.

Worse still is an unauthorised overdraft, when you either go over your overdraft limit or fall into the red without agreement with your bank. Both have horrendous punitive costs associated with them. We’ve heard stories of levies of £100 or more after going a few pounds over the limit.

Overdrafts are also a pre-cursor to the more extreme forms of credit. Once you hit your overdraft limit then there’s the temptation to apply for a consolidation loan to make the debt easier to service (but with more long-term pain) or short-term loan to cover yourself until your payday (putting off the pain for 30 days).

Each gives “breathing space” but just postpones the inevitable.

At your overdraft limit?

If you’re hitting your overdraft limit then you need to focus on your income and expenditure straight away.

You’re running short of money and need to reduce your spending now, to avoid going over the limit, and in the future, to reduce the debt. Otherwise you’ll start to consider payday loans and debt consolidation as an answer to your financial problems, when they’re nothing of the kind.

You need to interrogate your current spending by doing a personal budget, and find where savings can be made. You should also work out how to maximise your income. If you do this it might not be a pleasant few weeks until the next payday but it’ll avoid much worse problems later on.

If you’re hitting your limit each month then you need to talk to us, otherwise you’ll have a never-ending debt problem. Use our online counselling service Debt Remedy or contact us.

An overdraft might not seem like a debt, but the consequences can be anything but debt free.

If you want more knowledge on debt, follow MoneyAware on Twitter. Every weekday morning at 10am we’re tweeting #clearaboutdebt, talking about money management terms in plain English.