Overdrafts have proved to be a very useful tool for millions of people world-wide. However sometimes they can cause financial strain, and it’s often those who most need an overdraft facility that have been hit hardest with unarranged overdraft fees.

So, where did they come from and how did the overdraft market evolve into such a highly-profiting business? What does the future hold for overdraft fees and short term lending in general? We hope to answer a few of these questions.

When was the first overdraft approved?

Naturally, necessity is the mother of invention, and the same goes for overdrafts. There’s not a lot of information about the very first overdraft or why the bank decided to offer it however the first example of this type of cash-credit facility stems from around the early 1700s when one man needed more money than he had in his bank account.

It’s a simple premise and up until that point, people would have to get a bank loan against securities. But in this instance, the bank decided to give the man the ability to temporarily withdraw money from his bank account that he didn’t actually have. And thus, the overdraft was born.

It doesn’t sound that different to a normal loan, right? But imagine this is the first time anyone had been able to spend money as though it was their own, despite the fact their bank balance read £0.

Why were overdrafts so popular?

Of course, this kind of innovation sky-rocketed in the financial world. Suddenly people and businesses were able to borrow without having to fill out application upon application and attend meeting after meeting. The money was available on the understanding it would be paid back very shortly – typically when the account owner was next paid.

Overdraft Fees

It’s difficult to say when overdraft fees started to surface but it’s not difficult to understand why. Banks were providing a service to their customers that they could easily make a profit from as it cost very little to the bank itself.

Fast forward a few hundred years and borrowing became more mainstream and available to the wider general public, rather than just the high society. However, this also meant more rigorous consequences of failing to repay your borrowing on time as there was a bigger risk of debts not being repaid (simply because people with less disposable income now had access to overdrafts).

Photo of monopoly board game showing the car going to jail

Consequences of Defaulting on a Payment

Many years ago, punishment for failing to repay loans on time often included a prison sentence. While at the time this may have seemed like a rational and logical consequence for defaulting on a loan repayment, the financial industry has come a long way to recognise that there are many reasons people fail to make their repayments on time, and most of which occur outside of the borrower’s control.

Thankfully, prison is not a consequence of poor financial management anymore, however there is still evidence that those more susceptible to financial difficulty are often paying more for their borrowing. The consequence of having a bad credit history can often be an increased cost of credit.

Unarranged Overdrafts

An unarranged overdraft is an overdraft without formal approval from the bank. It normally occurs when a person makes a payment or a payment is requested from a person’s account and that person does not have the funds to cover the payment, but the payment is successful anyway. Up until 6th April 2020, the fees for using an unarranged overdraft (consciously or not) could be huge, and even up to five times the cost of a payday loan.

Thanks to a review from the FCA, unarranged overdraft charges have now been capped so borrowers are not subject to paying huge fees when they may have no other choice – a large number of people who frequently use an unarranged overdraft have no other choice as they have restricted or zero access to authorised credit products. The new unarranged overdraft aims to level the playing field for all borrowers.

Alternatives to Overdrafts

While arranged overdrafts can act as a good safety net for emergency or unexpected expenses, some people feel as though having access to revolving credit might encourage them to borrow more often and consequently lead them into debt. If you only need to borrow when the odd occasion arises, it might be worth considering alternative forms of borrowing.

You should always try to budget for the month and keep a small amount of cash handy in cases of one-off or unexpected purchases – we know it’s not borrowing but it is the cheapest way to meet your financial commitments. If you get a slightly larger paycheck one month, consider putting the extra money away for a rainy day.

However, if this isn’t possible or you’re nearing the end of the month when an unexpected expense arises, a one-off loan might be more suitable. You could try a payday loan; and as you have to make an application each time you want to borrow, there’s no risk of accidentally spending money you don’t have (as with an overdraft).

In any case, always consider your financial circumstances at the time of repayment when it comes to any kind of borrowing. While imprisonment is no longer a consequence of failing to make your repayments on time, it can make credit harder to obtain in the future.