Don't Rely On This `Safety Net'

Is an overdraft your most dangerous debt?

As the cost of living in the UK continues to soar, it's no wonder some of us are finding our bank accounts bare by the end of each month.

While going into debt to make ends meet is hardly ideal, unsecured lending statistics suggest many of us have edged into our overdrafts during the past year.

But what if you're reliant on being in the red for a few weeks each month, and your bank decides your overdraft days are over?

Cuts

A couple of weeks ago, TMF HQ received a call from a site user who was shocked -- and stressed out -- by his bank's decision to drastically cut his overdraft limit.

There was little warning or explanation for this. Although the man's balance was within his existing overdraft limit, it was higher than his new limit -- which, rather laughably, his bank informed him had been set with a `buffer' in place!

After scouring internet forums and discussion boards, I realised this reader wasn't alone. Perhaps as a result of the credit crunch, several banks seem to be calling in overdrafts -- in some cases, ones that have been in place for years.

Then, I found my own overdraft completely cancelled -- never mind cut!

According to the letter I received, I had 30 days to repay the full amount. After that, any overdrawn balance on my account would be subject to the "usual tariffs".

Roughly translated, that meant I could face punitive unauthorised borrowing fees and sky high interest charges if I didn't clear the debt. Yikes!

When I asked my bank why, they informed me I had not credited the account with enough payments over the previous 12 months and was therefore in breach of its terms. However, it's been more than two years since I paid my salary into that account -- so I was surprised to be so unceremoniously reminded of the rules.

My overdrawn balance was relatively small, so I paid it off last week using a credit card balance transfer.

But I can't help feeling concerned that people with larger debts would face a much tougher challenge in similar circumstances.

Overdrafts In Theory

To get a better idea of how banks view their provision of overdrafts, I spoke to the British Bankers' Association, the Financial Services Authority and the Banking Code Standards Board.

In theory, an overdraft is a flexible form of borrowing which allows a user to get on top of temporary cash-flow problems.

As you can withdraw cash from an overdraft in the same way you take out your own money, you can supposedly ensure that you only borrow what you need -- and you're free to pay it back whenever you like, with no penalties.

Moreover, overdrafts are generally fast and free to arrange -- another boon if you're headed for choppy financial waters and need a quick fix.

The vast majority of banks state in their terms and conditions that an overdraft facility can be revoked at any time.

Due to the `impermanent' and `informal' nature of overdrafts, they're not regulated in the same way as credit cards or personal loans under the Consumer Credit Act.

Overdrafts In Practice

Unfortunately for borrowers, overdrafts do not always operate in the way they are supposed to.

I have a close friend who's been consistently overdrawn in her graduate account by over £1,000, for more than four years! It doesn't take a genius to see there's nothing about this arrangement that implies it's `temporary'.

However, she's at risk of having her overdraft facility cancelled at any time -- and she'll have little recourse to complain.

Some overdrafts are allowed to persist far beyond their theoretical `stop-gap' role. This almost certainly suits the institutions that provide them, as overdraft interest rates tend to be far higher than the rates on personal loans -- or even credit card debts -- of equivalent size.

Unfortunately, while it can seem to provide the consumer with a semi-permanent income `extension', an overdraft is an expensive, insecure and unpredictable way to borrow.

What Can I Do If My Limit Is Cut?

If you're informed your overdraft is soon to be cancelled or cut, you should contact your bank immediately.

If you allow your balance to stay negative past the overdraft cancellation date, it's likely you'll be hit with bank charges -- and these will push you further into the red.

Also, under the terms of the Banking Code most institutions should arrange a repayment plan or `reducing overdraft' for you, based on what you can afford to pay them back each month. If they don't offer you this lifeline, ask for it.

Even better, consider transferring your overdraft balance to a 0% credit card -- a move that could massively reduce your interest payments and help you move far faster towards clearing the debt.

And don't forget, being overdrawn doesn't preclude you from switching banks. Alliance & Leicester's Premier Current Account is a top choice for anyone overdrawn. Switchers will receive a £100 sign-up bonus, and an overdraft at a typical rate of 0% for 12 months. However, if your overdraft is more than £1000, it may not be fully matched in your new account -- and this offer does not apply to existing Alliance & Leicester customers.

If, like many others, you've become accustomed to ignoring the little minus sign in front of your bank balance, now could be the time for a re-think.

Getting over your overdraft might be tough, but it can be done.

And, bizarrely, without this supposed `safety net', your finances could feel far more secure.

More: How To Beat Overdraft Charges |Use This Credit Card To Clear Your Overdraft