The average overdraft rate’s now 19% (see MSE news) yet many still have a block when it comes to considering it a debt. A classic example is using a bank account to pay off credit cards, usually at a higher rate and with the added potential of bank charges…
So the first thing for everyone who’s overdrawn to do is…
Check your overdraft rate – it’s probably higher than you think
Many are unaware of the real cost of being overdrawn. Certainly when I do telly money makeovers, people either never know or get the rate totally wrong.
So if you are overdrawn it’s crucial to check exactly what the rate is and how much it is costing you (also consider ditching and switching to a 0% overdraft).
These days many of the major credit cards typical APRs are 16.9% and overdrafts are often higher.
It’s a debt like any other.
I’ve often heard people talking about overdrafts as if they’re different to credit cards and loans – they’re not. It may be psychologically confusing as they’re wrapped in with your day-to-day banking facility, but an overdraft is just a form of easy access loan.
It shouldn’t be given any special treatment. If you’re in debt and need to decide where your cash goes, the golden rule is focus on clearing the most expensive debt first (see credit card shuffle for full explanation), as it’s the one growing fastest, and only pay the minimums on all other debts.
If your overdraft is the most expensive, then it’s the one to clear first.
You may be better off spending on a credit card than an overdraft
Yet to explain my point, I’m going to focus purely on how to choose the right tool to borrow with for the time being if you are in that situation.
|The following is Ivanna Spend’s current finances. She has an overdraft and one credit card.
Before reading on, it may be a useful exercise to think for a second about what she should do with her future spending and repayments.
Bank charges above the limit:
£35 per transaction
The Worst Thing….
Sadly, what too many people do is try and clear their credit card by paying unthinkingly out of their bank account.
If Ivanna does that, as the overdraft is at a higher rate than the credit cards, she’s effectively shifting the debt to a higher interest rate costing her more. Worse is, if she clears the whole thing and ends up hit by the bank charges, they are in a different cost league than mere interest rate.
The Best Thing…
Ivanna should only pay the minimum off her credit card, and start using it instead of her debit card for daily necessary spending.
This may seem surprising, but the credit card is cheaper. Do that for a while with a balanced budget and you’d soon end up with this scenario.
Credit card debt:
Effectively she’s shifted the overdraft to the credit card, which is at a cheaper rate, and avoided bank charges. Of course, better still would be to get a 0% credit card for spending if her credit score allows, so effectively she’s moved her overdraft to 0%. Then pay it off while there’s no interest.
PS. The exception to the rule. The one time that you may want to use your overdraft to clear a cheaper credit card, is if it enables you to pay off the card in full.
This is because clear a card in full and you (usually) dont’ pay any interest. E.g. If you have £1,000 debt on the card and pay £980 off, you’ll usually pay interest on the WHOLE £1,000 for the month – yet pay £1,000 off and you pay no interest.
So slipping a touch into your overdraft so you can clear in full can be worth it in this specific scenario (thanks to Gordon the (not so) Moron in the forum discussion for noting this).