A client of mine was asking me about who had the best interest rates for a regular, monthly savings account last week and while I was checking some banks websites to see what each was offering, I inadvertently stumbled across one particular bankâ€™s current account offering.
I clicked on the section marked overdraft, because this is an area of peoples finances that I find some neglect and take no notice of, and then there are others who complain that they are always in their overdraft, and havenâ€™t the money to bring it up to date.
The common denominator for both type of person is that they have no idea how much interest they are being charged and subsequently have no idea how much it is costing them each year.
I forgot about checking those regular savings rates for a minute and started to investigate further and looked at what overdraft rates each bank was offering. And I found that the average rate was about 15% or 16% â€“ or so it would seem (read on). Thatâ€™s one hell of an expensive loan â€“ because thatâ€™s precisely what an overdraft amounts to.
So, I wasnâ€™t surprised when one institution wrote on their website the following: â€œLike some extra breathing space for your finances or need some extra money before payday? Borrow up to a maximum of one monthâ€™s salary.â€
Fantastic - arenâ€™t they very nice for offering you this? Call me a cynic but I wanted to see what was in it for them. I discovered that if you earn â‚¬2,500 per month and you arrange an overdraft for this amount but you run out of money during the month, itâ€™s OK. Thatâ€™s because you can use your overdraft â€“ so you become overdrawn by, say, â‚¬1,000. Of course what happens in this all-too-familiar scenario is that when your salary of â‚¬2,500 is lodged, you are only in credit of â‚¬1,500, so itâ€™s unlikely that you will be able to survive until the end of the month without going into your overdraft again. So hey presto - mission accomplished, that is what your bank wants to happen to you, because the likelihood is that for probably half the month, for the foreseeable future, you are always going to be overdrawn and charged 15% or 16% for the pleasure.
So how much is it going to cost you each year? If, for example, you are overdrawn by â‚¬750 and you are being charged 15% then it is costing you â‚¬112.50 each year.
For me, that is an expensive loan. And that is not factoring in either the fees they charge for setting up the overdraft in the first place and the renewal fee after the original agreed term is about to expire.
And hereâ€™s another thing. If you go over the amount your bank has approved you for, they will charge you a surcharge which could be another 7% on top of the 15%, so your overdraft could be costing you 22%.
These rates are insane and bordering on â€œpayday advanceâ€ type loans which came in for so much criticism in the UK recently, where some companies charge rates of interest at 25% or more to people who need â€œshort-term loansâ€ (they never are) because they ran out of money and need an advance before they get paid â€“ I asked myself: â€œIs there much difference to an overdraft if you donâ€™t manage it properly?â€
Because here is the thing, I actually calculated the cost of how much in APR terms, and this really is the rate banks should be using when giving examples of how much an overdraft is actually costing you. If you were overdrawn by â‚¬750 over 12 months â€“ guess what the real rate of interest you are being charged is? 30.19%
And weirdly, the amount they charge you actually gets worse the less you owe them. If, for example, you were overdrawn by â‚¬250 and they applied the overdraft and surcharge rates to your balance, the real cost of being overdrawn by just â‚¬250 is a whopping 45.16%. Surprised? I thought you might be.
Donâ€™t get me wrong, overdrafts can be very useful and I believe important to have in place. I have one myself, but if they are abused in that you are always or at some stage in the month overdrawn and 15% or 22% kicks in, they can be seriously bad for your wallet.
So, how can you manage your overdraft then each month? Your starting point is to know what your overdraft limit is so that extra surcharge interest rate doesnâ€™t kick in and â€“ secondly and most importantly â€“ you need to keep track of how much you spend each month and how much you have in your account.
You can only do this I think by creating your own budget or spending planner, as I like to call it, which makes it easy to track where you are spending your money so you donâ€™t wonder at the end of the month where it went â€“ and how did you end up overdrawn again?
Donâ€™t forget there is a monetary cost to you each month if you spend more than you earn and you shouldnâ€™t take comfort from having an overdraft as your safety net, because itâ€™s a bloody expensive net.
Another tip to avoid going into the red each month is to check the dates when you pay certain things. If any regular payments like car loans or credit card payments go out of your account just before you get paid, then if possible change them to just after you get paid. Itâ€™s a simple thing to do, but very effective.
Also, if your bank offers text alerts, they can be particularly useful, and that would be the first thing I would sign up to. Because they will send you a text alert when you are near or about to become overdrawn so you can lodge money, if you have it, into your account or transfer funds from another account you may have. This is particularly helpful for people who donâ€™t track their spending or never have an idea what is or isnâ€™t in their account.