What Is an Overdraft and How Does It Work?

What Is an Overdraft and How Does It Work?
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When you have an overdraft, you can borrow money through your current account. So, it can be a useful tool for using additional funds when you need them. Let us explore in detail exactly how an overdraft works.

How does an overdraft work?

When you set up an overdraft with your bank, which is known as an arranged overdraft, you can basically dip into money when your account balance goes below $0. You can use as much of your overdraft as you like, up to its set limit.

For instance, if you have a $1,000 overdraft, you can use funds from your account that are under your $0 balance but which do not exceed the $1,000 limit. Most banks offer overdrafts to qualifying account holders, but not all banks provide overdraft options.

Do you pay interest on an overdraft?

You will be charged interest on your overdraft. The more funds you borrow from your overdraft, the higher the amount of interest will be. When you set up an overdraft with your bank, make sure you know how much the interest rate is before you start spending money from your overdraft. Although there are certain banks with no overdraft fees.

It is important that you are able to pay the interest rate. Most banks have overdraft cost calculators so that you can always see how much the interest rate will be depending on how much you spend from your overdraft.

Some Banks Offer No-fee Overdraft Coverage

You will not always have to pay fees for overdraft use, as long as you go with the right bank. For instance, when you use Sofi's bank app, if you overspend from your current account and go into your overdraft, you could spend up to $50 of your overdraft without having to pay any fees.

How do you pay back an overdraft?

The quicker you can pay your overdraft back after dipping into it, the sooner you can avoid having to pay interest fees. So, it is a good idea to transfer funds to pay off your overdraft as soon as possible.

If you spend a lot of money from your overdraft, it could take time to pay off the amount, but even paying small amounts over time will help to reduce your overdraft costs, which means you will have less to pay overall.

What is an unarranged overdraft?

An arranged overdraft, as briefly mentioned above, is an overdraft that you arrange with your bank. Arranged overdrafts have set limits that you cannot go over and they typically charge interest.

An unarranged overdraft refers to spending over what you have in your current account. If you spend more than you have available, you will be charged a fee and have a deadline to pay the fee. You should always try to avoid going into an unarranged overdraft.

Do you need an overdraft?

Now you know how overdrafts work, you will be better positioned to determine whether it could be useful to have one. Overdrafts can be incredibly beneficial to many people as they allow account holders to borrow money when they need it.

You could use a few dollars from your overdraft because you want to buy a new coat that is on sale but you would not have the available funds until payday or you could have a large emergency expense to pay, such as a damaged roof that needs repairing.

You can use the funds from an overdraft for any purpose.

The thing you need to remember is that you will be paying interest. It can be more than beneficial to pay that interest in return for the perks you will receive, but if you get heavily into debt and find it hard to pay off your overdraft, you could end up with higher monthly outgoings, as you will be paying interest each month.

If you find you are struggling with debt, check out these helpful tips for getting out of debt. It could also be useful to find out about overdraft protection and how it works.

Whether you should get an arranged overdraft with your bank, or consider switching to another bank to get an overdraft with more favorable terms, is heavily dependent on your own personal and financial circumstances.

Generally, overdrafts are great for short-term use but not for long-term funding.
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