If you’ve ever applied for a loan, you’re probably familiar with credit scores and their importance. These scores provide a snapshot of your borrowing behaviour and are a key factor in determining your ability to obtain credit in the future.
Understanding what improves your credit score is crucial for maintaining a healthy financial profile. In this context, it's essential to ask: How does an overdraft affect your credit score?
This article will take an in-depth look at overdrafts—how they work, their effect on your credit score, and the best practices for managing them to safeguard your credit health.
What Is an Overdraft?
An overdraft allows you to spend more money than you have in your bank account, up to an agreed limit, which you must repay later. It acts as a financial safety net, preventing situations where your debit card might be declined. It's crucial to exit your overdraft quickly to avoid interest and fees.
Here's a basic example of how an overdraft works: You have £50 in your account and a £150 bill is due. With an overdraft limit of £500, the payment will use your £50 balance and £100 from your overdraft, meaning you’ve now utilized 20% of your overdraft.
Types of Overdraft
1) Authorized Overdraft
An authorized overdraft also referred to as an ‘arranged' overdraft, is a pre-arranged agreement with your bank, allowing you to borrow up to a specified limit.
This type of overdraft typically comes with agreed-upon fees and interest rates. It’s a formal arrangement that helps you manage temporary cash flow issues without incurring excessive charges.
Banks typically charge an annual interest rate for both arranged and unarranged overdrafts, so there won’t be additional fees or charges beyond the interest rate.
2) Unauthorized Overdraft
An unauthorized overdraft, also known as an ‘unplanned' or ‘unarranged' overdraft, occurs when you exceed your account balance without prior authorization or exceed the limit of an authorized overdraft. This type of overdraft typically incurs higher fees and interest rates than authorized overdrafts and may negatively affect your credit score, resulting in additional charges from your bank.
3) Student Overdraft
Student overdrafts are a specific type of arranged overdraft designed for students. They function like arranged overdrafts but generally offer interest-free borrowing while you are studying. Once the interest-free period concludes, standard overdraft fees apply. These overdrafts are typically available through student bank accounts.
This type of overdraft is typically offered as part of a student bank account.
Here's the information in a table format:
Type of Overdraft | Description | Interest Rates | Fees | Special Features |
|---|---|---|---|---|
Authorized Overdraft | Pre-arranged with your bank, allowing borrowing up to a set limit. | Typically lower, as agreed in the arrangement. | Charged as per agreement. | Formal arrangement with a set limit. |
Unauthorized Overdraft | Occurs when you exceed your account balance without prior approval. | Higher, as it’s considered a breach of terms. | Higher fees and charges. | May negatively impact your credit score. |
Student Overdraft | Special overdraft for students, encouraging account openings. | Usually interest-free during the study period. | Standard fees apply after the interest-free period. | Interest-free while studying; higher limits. |
Does Having an Overdraft Affect Your Credit Score?
Simply having an overdraft is unlikely to significantly impact your credit score. However, the way you manage it can have both positive and negative effects.
When you use an overdraft, it appears as a debt on your credit report. Lenders can see both your overdraft limit and the balance you’re using. Maintaining an arranged overdraft within the agreed limit and repaying it regularly can boost your credit score, as it indicates reliable borrowing behaviour.
Conversely, regularly exceeding your overdraft limit or using an unarranged overdraft can harm your credit score. It signals potential financial difficulties to lenders and may impact their decisions on your future credit applications.
| Action | Effect on Credit Score |
| Decreasing Overdraft | Has a positive impact: Reducing your overdraft balance shows better financial management and can improve your credit score. |
| Increasing Overdraft | Has a Mixed impact: Increasing your overdraft limit might signal higher borrowing capacity but could also suggest increased financial risk if not managed properly. |
Understanding the different types of overdrafts and their effects on your financial health is crucial. Here’s a breakdown of common overdraft types, their descriptions, and their impact on your credit score:
| Type of Overdraft | Description | Impact on Credit Score |
| Arranged Overdraft | Pre-approved borrowing limit with agreed terms. | Has a positive impact: If used responsibly; shows good financial management within agreed limits. |
| Unarranged Overdraft | Exceeding balance without prior approval or going beyond the limit. | Has a negative impact: indicates financial mismanagement and may incur higher fees and impact credit score adversely. |
| Student Overdraft | Special overdraft for students with potentially interest-free borrowing during studies. | Has a positive impact: if managed well; shows financial responsibility, with additional benefits while studying. Has a negative impact: if mismanaged or if it turns into an unauthorised overdraft after the interest-free period. |
How does paying off your overdraft improve your credit score?
Paying off your overdraft can positively impact your credit score. Responsible use and timely repayment of your overdraft are reflected on your credit report as debt, providing lenders with insight into your overdraft limit and usage.
By paying off your overdraft, you reduce your overall debt, demonstrate financial responsibility, and lower your credit utilization ratio. This not only helps avoid negative marks on your credit report but also contributes to a positive payment history while preventing additional fees and interest charges.
How to Manage Overdraft to Protect Your Credit Score
By following the following steps, you can manage your overdraft wisely and protect your credit score.
- Stay Within Your Limit: Stick to your agreed overdraft limit to avoid extra fees.
- Make Regular Repayments: Pay off your overdraft on time to prevent interest buildup.
- Monitor Your Balance: Track your account balance to avoid overspending.
- Avoid Unarranged Overdrafts: Don’t exceed your limit without approval to prevent fees and credit score damage.
- Review Overdraft Terms: Know your overdraft’s interest rates and fees to avoid surprises.
- Set Up Alerts: Use alerts to monitor your limit and payment deadlines.
- Consider Alternatives: Explore other financial options to avoid relying on overdrafts.
Overdrafts aren’t meant to be maxed out monthly. Make sure to pay off your balance regularly to avoid costly fees and protect your credit score.
Can an overdraft improve your credit rating?
Using your overdraft wisely and repaying it regularly can positively impact your credit rating. Overdrafts are noted on your credit report, showing lenders your limit and usage.
Responsible overdraft use, including staying within your limit and making timely repayments, typically won’t harm your credit score. In fact, it can reflect well on your financial management.
However, exceeding your limit or using an unauthorized overdraft can damage your credit score, indicating poor financial control.
If you’re managing an overdraft, consider alternatives like a debt consolidation loan, which might offer a lower interest rate and help you save money.
Many overdrafts have high APRs, so switching to a loan could reduce your costs and improve your repayment strategy. Use our free eligibility checker to explore borrowing options and find the best solution for you.
Read Also: Debt Consolidation Loans For Bad Credit
Why is a credit score important?
Credit scores play a vital role in your financial health, influencing your ability to secure mortgages, credit cards, and auto loans, as well as affecting rental applications, insurance premiums, and even job opportunities.
A higher credit score improves your chances of approval for credit products, helps you secure lower interest rates, and can lead to better rental and insurance terms. It may also impact utility service setups and employment prospects.
Maintaining a strong credit score is crucial for accessing favourable financial products and enhancing various aspects of your financial life.
What Happens If You Can’t Pay Off Your Overdraft?
If you can't repay your overdraft, your bank may freeze your account, blocking access to funds, including your salary. Banks often charge monthly fees and setup fees for overdrafts, making them costly. Late or missed payments can harm your credit score and remain on your record for six years, increasing future borrowing costs.
To avoid these issues, it’s crucial to keep up with overdraft repayments. Consider creating a repayment plan by cutting non-essential expenses. If you’re struggling, talk to your bank for potential solutions and seek advice from organizations like MoneyHelper or StepChange.
Using your overdraft occasionally and paying it off regularly shows lenders you manage borrowing well, but maintaining a negative balance long-term is expensive. Relying on your overdraft monthly signals poor spending management to lenders.
Paying off your overdraft is better than removing it, as it increases your overall credit limit and helps avoid missed payments. If you struggle to avoid using it, consider reducing the limit or using a separate account for daily spending.
Alternatives to Overdrafts
- Credit Cards: Flexible borrowing with interest-free periods; helps build credit if used responsibly.
- Personal Loans: Lump sum with fixed repayments; often have lower interest rates than overdrafts.
- Emergency Savings Fund: Reduces reliance on overdrafts by covering unexpected expenses.
- Credit Union Loans: Lower interest rates and flexible terms compared to traditional banks.
- Flexible Savings Accounts: Easy access to funds without overdraft fees.
- Family or Friends: Interest-free borrowing; manage carefully to avoid relationship issues.
These options can provide more favourable terms and financial security compared to overdrafts.
Frequently Asked Questions
1- Will an overdraft stop me from getting a mortgage?
An overdraft won't automatically prevent you from getting a mortgage, but it can affect your application. Frequent or mismanaged use can harm your credit score and suggest financial instability to lenders.
However, if you use your overdraft responsibly and maintain a strong overall financial profile, it is less likely to hinder your mortgage approval.
How you use your overdraft can influence your mortgage approval and the amount you can borrow. However, having an overdraft alone won't prevent you from getting a mortgage. Most lenders will consider your application as long as you don't heavily rely on the overdraft.
2- Why is overdraft not good?
Overdrafts can be problematic due to high interest rates and fees, especially for unauthorized use. If you exceed your overdraft limit without authorization, your bank may charge you additional fees.
The bank can also demand repayment of the overdraft amount at any time, though this usually occurs only if you encounter financial difficulties.
