Overdrafts versus payday loans

When you need to borrow money, which is the better option?

Iona Bain – Virgin Money Living Mentor

by Iona Bain | Independent Money Mentor

Founder of the Young Money Blog and author of Spare Change


You’ve tried everything – the lottery, the car boot and the busking session that will live in infamy in your local town square – and you’re still short on cash. A payday loan or overdraft can seem like an alluring option. But both are best avoided unless absolutely necessary. Whichever you choose you will have to pay a high cost for the convenience – one you might not be able to meet. I’ve taken a look at payday loans and overdrafts, asked what risks they pose and offered some alternative options.


Payday loans

Payday loans allow you to borrow up to £1,000 and the money will be deposited in your bank account usually within a day. But the annual percentage rate or APR (the standard way to measure and compare the cost of borrowing) is usually at least a whopping 1,000%. This APR would mean that for every £10 borrowed you’d repay £110, if you repay it in a year.

Thankfully, payday loan interest is now capped. You pay no more than 0.8% of the loan’s value per day and you shouldn’t pay back more than twice the loan amount. But payday loans are still one of the most expensive borrowing options out there and you will pay interest right up to the cap. The payday loans industry has a lousy reputation for customer service and you may end up paying costs you didn’t expect to.

Another reason not to take the payday loan route unless it’s absolutely necessary: they may damage your credit score. All lenders can access your borrowing history through a credit reference agency and they may turn you down for credit when you most need it in future (such as for a mortgage) because they may deem payday borrowers too risky.


Overdrafts

An overdraft is a borrowing service offered by your bank on your current account. If you spend beyond the funds in your account you are using an overdraft to borrow from the bank. There are two types of overdraft. An arranged overdraft has a limit that either comes with the account or is agreed between you and the bank. An unarranged overdraft, as you may have guessed from its name, either goes past the limit of an arranged overdraft or you don’t have an arranged overdraft in the first place. Either way, you pay far more to use an unarranged overdraft, making this one of the costliest ways to borrow. 

Overdraft charges can be notoriously difficult to understand and compare, which is a far from ideal situation when the people needing the overdrafts are often stressed and short on time. Arranged overdrafts usually comprise interest and/or fees. Unarranged overdrafts can come with a raft of daily, monthly and transaction fees that quickly add up. Overdrafts should only ever be used for short-term borrowing you know you can repay. You may struggle to get your head around, let alone pay, the charges involved. If you think you may use your overdraft, always speak to your bank first to try and limit the charges. You may want to consider a current account with an interest-free overdraft or buffer.


The alternatives

Credit Unions

Before using a payday loan or your overdraft, always check if cheaper credit is available elsewhere, even if you have to wait longer. Credit unions are co-operatives that look after their members’ interests. If you join, you can get a loan with a maximum APR of 42.6% but you will also be required to save money while you borrow.

A ‘credit builder’ card

A credit builder card is a way of accessing credit, whilst at the same time improving your credit score – by making repayments on time you’ll prove you can manage money responsibly and so boost your credit profile for the future. They usually have an APR of between 24% and 40%, and you can apply for one even if your credit rating has taken a battering.


Finally, bear in mind that borrowing money is a sign you need to fix your finances. Start budgeting today so you know exactly where your money is going.

Before making financial decisions always do research, or talk to a financial adviser. Views are those of our mentors and customers and do not constitute financial advice.