What is an overdraft?

When you take money out of a bank account beyond the funds you have in there, in other words, if you hit zero but keep withdrawing funds, you enter an overdraft. These overdrafts can be pre-arranged or unarranged, and different banks will have different terms and penalties for entering into an overdraft.

What are the hidden costs of an overdraft?

Overdrafts are a double-edged sword. Borrowing extra money may occasionally help, but it has to be done carefully and responsibly. The main issue is that overdrafts encourage you to spend money you don’t have, often at a very high cost, causing two kinds of debts: financial debt and what we call ‘bad habit’ debts.

Financial debt is a problem because overdrafts are dangerously expensive. If you can’t afford to pay it off, it may affect your credit score- especially in cases with an unarranged overdraft- because it signals to lenders that you can’t manage your finances.

The bad habits debt is often more insidious. Unlike financial debt that you can clearly measure with numbers, bad habits grow unnoticed, like lung cancer in smokers… until the day doctors show you the extent of the damage. When borrowing becomes habitual, your debt can get out of control- and you might not see the full extent of the damage until it’s too late. Overdrafts and cigarettes are the most widespread poisons that people can legally buy. The best thing you can do for your future self is to take control of your finances now. The sooner you confront your spending habits and realise the extent of your debts, the better.

What’s the deal with Starling?

Overdraft fees

Ahead of changes to overdraft guidelines provided by the Financial Conduct Authority, Starling has adopted a policy of risk-based pricing. This means that there are different interest rates for customers based on credit scores, which they say is used to reflect the true cost to them of lending. Depending on your credit score, an arranged overdraft with Starling has an EAR of 15%, 25%, or 35% variable. Putting those rates into context, if you get £500 into your overdraft with an EAR of 35%, you’ll be paying just over £25 in interest- if you can pay it back in two months. If it takes you a year to pay it back that’s £175. That’s a pretty tough break if you have a bad credit score.

Risk-based pricing for overdrafts is not unheard of and is a policy also used by Monzo. There are some obvious beneficiaries to such systems (I’m looking at you, good-credit dudes), particularly when many of the big banks are setting static (high) rates. If you have a bad credit score though, these tiered systems can end up costing you a lot more.

In most cases, Starling tries to prevent customers from entering unarranged overdrafts, and often they will block payments that exceed your limits. This is not a sure thing, however, but the good news is that any payments that do surpass those limits, will not be charged any interest. This system is designed for small, accidental overpayments, not big borrowing.

What is EAR?

EAR is the interest rate you would pay if your loan was taken out for a whole year. It takes into account the interest rate and compound interest (the interest you pay on your interest).

Getting rid of overdrafts

Remember, overdrafts are just another debt that needs to be paid off. If you want to live debt-free, Nova Money will help you pay off your debts and develop sustainable financial habits.

You can start for free, and eventually unlock advanced features for £14.99/month - which is a fraction of what banks would charge for having an overdraft.