How Can Overdrafts and Credit Cards Impact Your Finances?
Overdrafts and credit cards provide quick access to funds in an emergency but can snowball into massive interest and fees if used irresponsibly. Let’s examine how they work:
What is an Overdraft?
Overdrafts are arranged with your bank and attach seamlessly to your current account. They allow you to access more funds than your current account balance, up to an approved limit.
For example, if your account balance is £500, but your overdraft limit is £1000, you could withdraw up to £1500 total. You can access your overdraft in the same way you’d access your current account balance – e.g., cash withdrawals, cheques, bank transfers and debit card spending.
Typically, overdrafts carry high interest rates, often 19% to 39%. These are usually much higher than even credit cards, sometimes reaching nearly 40% APR.
If you exceed your overdraft limit or don’t repay quickly, additional fees might also be incurred on top of interest, such as daily usage fees. Arranged overdrafts may also come with a set monthly fee regardless of how much you spend.
What is a Credit Card?
Credit cards function as revolving lines of credit. They can be used to fund everything from day-to-day spending to larger purchases, such as emergency car repairs.
If you repay your credit card debt in full each month, you won’t be charged interest on it. However, you also have the option to carry a balance from month to month. You must make at least a minimum payment each month, but this is usually only 1-4% of your total balance.
Interest rates can be variable depending on the card, often ranging from 9% to 29% or higher. APRs generally fall between 9-29% but can sometimes exceed 30%, depending on your credit profile.
If used responsibly, credit cards provide convenient access to funds when needed. However, relying on them too heavily can lead to accumulating substantial debt at high interest rates. They may also come with fees and charges, such as penalties for failing to make the minimum repayment.
Should I Prioritise Paying Off My Overdraft First?
With limited funds, is eliminating your overdraft or credit card balance the smarter opening debt repayment move? Let’s examine the potential advantages of prioritising your overdraft first in detail:
01. High Interest Rates
Overdraft rates often exceed even high credit card rates. The highest arranged overdraft interest can be nearly 40%, though interest on unarranged overdrafts may be even higher.
This means overdraft interest may be costing you more than your credit card debt. If this is the case, paying it off as soon as possible could be a wise choice.
02. Overdraft Fees
Beyond interest, overdrafts may incur additional charges like transaction fees, daily fees or monthly usage fees. If you’ve exceeded your overdraft limit or not repaid it by the due date, these fees may be even higher, leading to your debt snowballing quickly.
If the fees for your overdraft are higher than for your credit card, paying it off first may help to prevent your debt spiralling out of control.
03. Cash Flow Problems
An overdraft is typically linked to your main current account, where your salary is paid. Clearing your overdraft can provide a sense of financial relief and security, ensuring that your wages aren’t immediately consumed by overdraft repayments.
This will allow you to choose where your money goes and prioritise the most important things first, such as priority debts and essential living expenses.
04. Stricter Bank Measures
If you’re continually in an unauthorised overdraft or exceed the limit frequently, the bank might take stricter measures, such as reducing your overdraft limit or removing the facility altogether.
Also, bear in mind that your bank can ask you to repay your entire overdraft in full at any time. If you don’t pay, they may even close your bank account completely.
05. Red Flag to Lenders
Regularly using your overdraft, especially if you exceed your authorised limit, can be viewed negatively by lenders. It can indicate to them that you’re struggling with cash flow or not managing your finances effectively. This could make it harder to borrow money in future.
Clearing your overdraft can help maintain a healthier credit profile, though it’s important to note that high credit card utilisation may also be detrimental.
Should I Prioritise Paying Off My Credit Card First?
On the other hand, here are some reasons why eliminating credit card debts before your overdraft could be advantageous:
01. Credit Utilisation Impact
Credit card balances have a direct effect on your credit utilisation ratio, which is a significant factor in your credit score. Reducing this balance can improve your credit score more immediately than reducing an overdraft. While consistently being in your overdraft may put off future lenders, overdrafts don’t have the same direct utilisation metric in credit scoring.
02. Revolving Debt
Overdrafts have a set limit, meaning your bank account can only ever be overdrawn by a certain amount. However, credit cards have a monthly limit – meaning debt can grow exponentially over time if you keep using your credit card. This can be especially dangerous if you’re only making the minimum payments each month.
03. Low Minimum Payments
Credit cards only require minimum payments as low as 1-2% of the balance, allowing high interest costs to persist. When only the minimum payment is made, interest keeps accruing at high rates and your balance never goes down. Credit card interest is also compounded, meaning you’re charged interest on the interest.
By paying off your credit card sooner, and then closing your account, you can avoid the temptation to keep spending and making only the minimum payments.
04. Reduced Monthly Repayments
As you pay down your credit card balance, the minimum payment required each month may decrease, improving your monthly cash flow.
Remember that you’ll save significantly on interest when you pay above the minimum payment. Putting extra funds toward credit cards lowers balances faster and reduces interest fees.
05. Soaring Interest
Some credit cards offer promotional interest rates for a specified period of time (such as 0% for the first 12 months). If this applies to your credit card, ensuring you pay off your debt in full before the promotional period ends can save you from suddenly accruing high interest.
What’s Better – Paying Off Overdraft or Credit Card First?
There’s no universal right or wrong approach. It depends on your specific debt amounts, interest rates, fees, and credit score circumstances. As you weigh whether to prioritise overdraft or credit card repayment first, keep these key considerations in mind:
01. Interest Rates and Fees
Mathematically, the debt with the highest interest rate costs you the most over time. Try to focus extra payments on the balance with the highest APR. This is sometimes known as the avalanche method.
Crunch the numbers – the debt with the higher rate means greater interest over time. Even a small rate difference adds up exponentially.
Beyond interest, weigh additional fees like overdraft daily or monthly fees that raise costs. Factor in all rates and fees to determine your most expensive debt, and then focus on it first.
02. Your Credit Score Goals
Regularly being in an unauthorised overdraft can be viewed negatively by lenders and might impact your credit score. Similarly, maxing out credit cards or only making minimum payments can harm your credit rating.
Look at your balances versus limits. If your credit card utilisation is high, prioritising the credit card debt might have an immediate positive effect on your credit score. But if you’re frequently in your unauthorised overdraft or always close to the limit, addressing the overdraft might be more beneficial.
03. Psychological and Emotional Aspects
Consider which debt causes you more stress or anxiety. For some, clearing a particular debt (like a credit card with a long-standing balance) can offer significant psychological relief.
The total debt amount may also come into play. Some people prefer to pay off smaller debts first (the “snowball method”) to achieve quick wins and boost motivation. Others choose to tackle larger debts first. Consider which approach aligns with your financial goals and personal priorities.
04. Options to Consolidate at Lower Rates
Consider balance transfer or personal loan options. For instance, if you have the option to transfer a credit card balance to a 0% interest card, it might influence your decision. On the other hand, a consolidation loan could potentially lower your rate on both debts, and it would eliminate the need to choose which debt to prioritise.
The decision to pay off an overdraft or credit card first is personal and should be based on a combination of financial logic and individual preference. Crunch the numbers, know the rates and fees, and seek professional debt advice if necessary.
When to Seek Debt Consolidation
If juggling an array of credit debts and overdraft borrowing, debt consolidation could provide an efficient solution through:
- Combining multiple debts into one loan with one monthly payment, which may be lower than both individual payments combined.
- Potentially lowering interest costs by securing a personal loan at a lower fixed rate.
- Eliminating overdraft and credit card fees.
- Simplifying payment tracking into one monthly bill with one due date per month.
- Helping pay debts off faster: if your interest rate is lower, more funds will go towards principal.
- Avoiding the risk of missed minimum payments across multiple revolving accounts.
While your specific financial situation will determine if consolidation is beneficial, it’s worth exploring when dealing with expensive, hard-to-manage debts across multiple accounts. Bear in mind that you may end up paying more in interest over time if you’re extending your repayment period.
Explore Your Debt Consolidation Options with Consolidation Expert
If you’re struggling with high overdraft and credit card payments each month, you may be wondering: ‘should I pay off my credit card or overdraft first?’ With a consolidation loan, you don’t need to make that decision. You could combine your debts into one simple monthly payment and may even save money in interest and fees.
Consolidation Expert can help explore your debt consolidation options. Apply online today to see if you qualify for a debt consolidation loan from one of our lenders.