Why banks are worse than loan sharks

I’ve been a financial journalist since January 2003. During this time, I’ve condemned many poor-value financial products, especially payment protection insurance, extended warranties, store cards, and other high-street rip-offs.

I never expected to do this...

Today, in an abrupt U-turn, I’m going to praise (rather than denounce) payday-loan providers. Thanks to their mega-high interest rates, these short-term lenders are often lumped together with loan sharks. Then again, several leading high-street banks make payday-loan providers, home-credit lenders and loan sharks look positively charitable.

Be afraid. Be very afraid!

The high-street loan sharks

For instance, here’s a situation where you’d be miles better off going to a payday-loan provider (or perhaps even a loan shark?), rather than a high-street bank.

According to one estimate, seven million British adults cannot borrow on the high street, so they are forced to seek credit elsewhere. These people can’t put another £100 on their overdraft or credit card, simply because they don’t have access to mainstream credit.

Let’s say that you badly need £100 to pay a vital bill, such as a gas, electricity or Council tax demand. For example, if you don’t pay up, then this service (or even your mobile) could be shut off, leaving you up the proverbial creek.

Therefore, if you need £100 in a hurry, what do you do? One way (and the wrong way) to solve this problem is to pay the bill from your current account and worry about any overdraft charges later. The snag here is that the fees and interest rates on unapproved overdrafts are shockingly high. Hence, even the cost of a small debt for a short time can be staggering.

Another alternative is to get a payday loan: a short-term loan which comes with an astronomically high interest rate -- in some cases, over 2,500% APR. You’d be crazy to choose a payday-loan provider over a respectable high-street bank, right?

Wrong. The following table shows the cost of a £100 unauthorised overdraft for 20 days at one payday-loan provider and four leading providers of current accounts:

Payday loan versus unapproved overdrafts

Source: speed-e-loans

Breakdown of charges: A&L and Halifax: £5 per day for 20 days; NatWest: £20 fee plus £90 maximum charge for returned items; Lloyds TSB: £20 per day for a maximum of 10 days.

As you can see, a 20-day payday loan would cost you £25.94 (made up of a one-off fee of £4.95, plus interest at almost 1% a day), for a mind-blowing APR of 2,686%. However, the unapproved overdrafts at four leading banks would cost between £100 and £200, making the payday loan the far cheaper option.

Incredible, isn’t it?

The big problem with APRs

Obviously, I’m not praising payday loans -- far from it. In fact, I’m actually attacking the cost of unapproved overdrafts.

Thanks to the quirks of the Annual Percentage Rate (APR) calculation, APRs do not provide meaningful comparisons in situations such as these. In fact, Halifax and the like can boldly advertise their overdrafts as being 0% APR, because they charges only fees and not interest. Alas, these fees are so high that they propel the true cost of this short-term borrowing into outer space.

I think that banks are being unfair and misleading by using high overdraft fees to disguise the true, underlying cost of borrowing. What’s more, it’s high time that the financial regulator acted to stamp out this sharp practice. Otherwise, dipping into the red for a few days will continue to cost an arm and a leg...

The easy way out

Of course, the easy way to avoid excessive fees and sky-high interest rates on borrowing is to plan ahead by budgeting in advance for big bills. Use our brand new online banking tool to help you keep track of your incomings and outgoings across all your different bank accounts and credit cards, and to categorise your transactions so you know what you are spending your money on.

Likewise, never go into the red without permission by running up an unapproved overdraft. Instead, contact your bank to arrange an approved overdraft or to increase your existing credit limit. This will be the cheapest option by far, costing a few pounds instead of hundreds.

In short, by talking to your bank before going overdrawn, you can avoid the ridiculous charges levied on unauthorised overdrafts. This could leave you hundreds of pounds better off each year. As stand-up comedian Michael McIntyre cheekily remarks, “It’s not rocket surgery!”

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More: Find cracking current accounts today | Obliterate your overdraft for good | Three great credit cards for borrowers