Overuse of Overdrafts: The Most Expensive Form of Legal Credit

Overdrafts can be a financial lifesaver for individuals and small businesses alike. Many use overdrafts as a readily available and convenient form of credit, especially when more traditional sources of personal credit or additional operating capital are unavailable. The individuals and businesses who rely upon overdrafts to cover cash shortages often view the fees they are charged for overdrafts as an unavoidable cost of doing business, but those fees can get to be awfully expensive – more expensive, in fact, than other personal and business costs that the individual would reject as being altogether exorbitant.

Banks have a love/hate relationship with overdrafts…

To be sure, overdrafts and the fees they generate are a pretty sweet deal for the banks, as they are able to collect many millions of pounds in overdraft fees every year. Despite the inordinately high profit potential that overdraft fees represent to the banks, however, roughly £5million worth of overdraft services are being taken away from small and medium enterprise (SME) owners every day, according to a Bank of England report that came out in October 2015. The elimination of overdraft services often amounts to a significant reduction in the working capital upon which many SMEs rely for their business to function.

Small businesses are seeking out alternatives to replace their lost overdraft services
In response to the loss of this relied-upon source of working capital, small business owners have sought out and used alternative funding and finance options, including secured loans from the Bank of England, an increase to the tune of £76 billion in 2015 alone. Ironically, the same banks that have been eliminating the highly lucrative overdrafts are beginning to offer those same business customers more traditional, less expensive forms of credit.

Individual account holders are being hurt, both by high overdraft fees and the removal of overdrafts

It’s not just businesses that are suffering; individual consumers are having overdraft woes as well. Individuals often get too dependent upon overdrafts, and some don’t even realise how much they are actually paying for what they thought was “free” banking. Part of this has to do with the “culture” in UK banking, which includes a lack of transparency about the real costs, but part has to do with consumers not educating themselves about these matters. In some cases bank customers are actually trapped with bank accounts that offer poor value, but they can’t switch because they have to pay off their overdraft debt. And even if they could switch banks, there is no guarantee that the new bank will offer the same – or any – overdrafts on the new accounts.

Breaking the overdraft cycle

Small business owners and individuals alike can free themselves from the seemingly unbreakable cycle of overdrafts, but doing so can be difficult. The most obvious solution is to avoid spending more than you have, but that is not always an easy course. The account holder who runs out of money before they run out of month might actually be unable to break the cycle, as the added cost of overdraft fees often equals or even exceeds the amount of shortfall in a given month, which ensures that the following month will also find the account in overdraft status. In worst-case scenarios, such as when the bank removes the overdrafts, the account might even go into default, resulting in its being closed and processed for collection.

There does exist a sort of saving grace that is becoming more available as banks are getting more liberal in their lending policies. For customers who lack the funds in savings to pay off their overdrafts (which would seem to constitute a majority of those who rely upon overdrafts), yet are still in good standing with their credit card accounts, a money transfer from the credit card to cover the overdrafts might be a viable alternative. While credit card debt typically carries a higher interest rate than other more traditional types of loans, that interest rate is still likely to be less expensive than the fees charged for overdrafts.

As a last resort, it might be possible to convince the bank to refund overdraft service fees that are deemed to be excessive or inappropriately applied. This is admittedly an unreliable process, as the lack of transparency into banking operations makes it difficult to prove that the charges were inappropriate.

Whatever method you choose to break free of the overdraft cycle, it is imperative that greater focus and commitment be made to ensuring that you don’t slip right back in. If nothing else, emerging from what amounts to a compounded cycle of overdrafts can be even more difficult to emerge from than was the original situation.

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