An overdraft is one of the most commonly used financial products in the UK and one of the most misunderstood. Whether it is a personal current account overdraft helping bridge a gap before payday or a business overdraft facility providing working capital flexibility, understanding exactly how overdrafts work, what they cost, and when they make sense is essential for sound financial management. This comprehensive AccFirm guide explains everything about overdrafts in the UK for 2026, including the FCA’s new rules on overdraft charging, business overdraft facilities, and the tax treatment of overdraft interest.
What Is a Bank Overdraft?
A bank overdraft is a form of short-term borrowing that allows you to spend more money than is currently in your bank account up to an agreed limit. When your account balance goes below zero, you are “overdrawn.” The bank provides the shortfall, and you repay it when funds are deposited into the account.
Key characteristics of an overdraft:
- Flexible: You borrow only what you need, when you need it you are not required to draw the full facility
- Revolving: As you pay money in, the overdraft balance reduces automatically there are no fixed repayment instalments
- Short-term: Overdrafts are designed as short-term, working capital facilities not for long-term borrowing
- Interest on balance used: Interest is charged only on the amount overdrawn, not on the full facility limit
- Facility limit: The maximum you can borrow is capped at an agreed overdraft limit, set by the bank based on creditworthiness
Arranged vs Unarranged Overdrafts
There are two types of overdraft, with very different costs:
Arranged (Authorised) Overdraft
An arranged overdraft is one you have agreed in advance with your bank. The bank sets a limit and an interest rate (expressed as an EAR Equivalent Annual Rate). Since the FCA’s overdraft reforms in April 2020, all arranged overdraft interest must be expressed as a single EAR percentage banks can no longer charge daily fees or monthly fees alongside interest. Typical arranged overdraft EAR rates range from 19% to 40% APR, depending on the bank and account type.
Unarranged (Unauthorised) Overdraft
An unarranged overdraft occurs when you spend beyond your arranged limit (or have no arranged overdraft) and the bank allows the transaction rather than refusing it. Since the FCA’s 2020 reforms, banks cannot charge higher fees for unarranged overdrafts than for arranged ones the same EAR applies. However, many banks now simply refuse transactions that would create an unarranged overdraft rather than allowing them and charging fees.
How Overdraft Interest Is Calculated
Overdraft interest is calculated daily on the amount overdrawn:
Daily Interest = (Overdraft Balance × EAR) ÷ 365
Example: You are £500 overdrawn for 10 days at an EAR of 39.9%.
- Daily interest: £500 × 39.9% ÷ 365 = £0.547 per day
- Total interest for 10 days: £0.547 × 10 = £5.47
For short periods, overdraft interest is relatively modest. The cost escalates significantly if you remain overdrawn for extended periods or if the balance is large.
Personal Overdraft: FCA Reforms and Current Rules
The Financial Conduct Authority (FCA) fundamentally reformed personal overdraft pricing in April 2020:
- Single interest rate: All overdraft charges must be expressed as a single EAR no daily fees, monthly fees, or usage fees alongside interest
- No higher unarranged charges: Banks cannot charge more for unarranged overdrafts than arranged ones
- Transparency: Banks must display the EAR prominently, allowing easy comparison between providers
- Opt-out: Consumers can opt out of unarranged overdrafts the bank will decline transactions rather than creating an unplanned overdraft
These reforms followed FCA research showing that high daily fees on unarranged overdrafts were disproportionately harming vulnerable customers with some overdraft products effectively charging equivalent rates of over 1,000% APR before the reforms.
Business Overdraft Facilities
For businesses, an overdraft facility provides a vital working capital buffer smoothing cash flow between paying suppliers and receiving customer payments. Business overdraft features differ from personal overdrafts:
- Annual review: Business overdrafts are typically reviewed annually the bank may reduce or withdraw the facility if the business’s financial position deteriorates
- Security: Larger business overdrafts may require a personal guarantee from directors or a charge over business assets
- Interest rates: Business overdraft interest rates are typically quoted as base rate plus a margin (e.g. Bank of England base rate + 3%)
- Arrangement fees: Banks often charge an annual arrangement or renewal fee for business overdraft facilities (typically 1–2% of the facility limit)
- Facility letter: A formal facility letter from the bank sets out the overdraft limit, interest rate, fees, and terms
Business Overdraft Costs 2026
With the Bank of England base rate at 4.5% in March 2025, a typical small business overdraft at base rate plus 3% costs approximately 7.5% per annum. On a £50,000 facility used to its full extent for six months, this represents interest of approximately £1,875.
Tax Treatment of Overdraft Interest for Businesses
For UK businesses, overdraft interest paid on a business account is a deductible expense for Corporation Tax (limited companies) or Income Tax (sole traders and partnerships) purposes provided the overdraft was used for genuine business purposes.
- Limited companies: Overdraft interest is a financing cost deductible in computing taxable profits, reducing the Corporation Tax liability
- Sole traders: Overdraft interest on the business bank account is an allowable business expense deducted from trading income
- Mixed-use overdrafts: If a business overdraft is used partly for personal expenditure, only the business-use proportion of interest is deductible
- Personal overdraft interest: Interest on personal overdrafts is never deductible for personal Income Tax purposes
Overdrafts and Credit Ratings
Using an overdraft affects your credit file in several ways:
- Arranged overdraft: Appears on your credit file as an open facility. Using it regularly and staying within the limit generally has a neutral-to-negative effect on credit scores lenders may view frequent overdraft use as a sign of financial stress.
- Unarranged overdraft: Historically a significant negative marker though since 2020, the impact has been reduced as unarranged overdraft charges are now aligned with arranged charges
- Overdraft balance on mortgage applications: Mortgage lenders review bank statements typically going back three to six months. Regular overdraft use even within an arranged limit can raise concerns about cash flow management
- Business credit: Business overdraft usage is visible to commercial credit agencies and can affect the business’s ability to obtain other financing
Alternatives to Overdrafts for UK Businesses
- Invoice finance: Advance payment against outstanding invoices typically provides 70–90% of invoice value immediately
- Business credit cards: Short-term, interest-free if cleared each month useful for smaller recurring expenses
- Asset finance: Hire purchase or leasing for equipment preserves cash flow
- Revolving credit facility: Similar to an overdraft but often at lower cost for larger facilities
- CBILS/BBLS successors: Government-backed business lending schemes for eligible SMEs
Frequently Asked Questions: How Overdrafts Work
Does an overdraft affect my credit score in the UK?
Yes regularly using your overdraft, particularly if you are near or at your limit, can negatively affect your credit score. It signals potential cash flow difficulties to lenders. Staying within your arranged limit and clearing the overdraft regularly minimises the impact.
Can a bank remove my overdraft facility?
Yes. Banks review overdraft facilities periodically and can reduce or withdraw them with notice typically 30 days for personal overdrafts and on review dates for business facilities. This can cause significant cash flow disruption if you rely on the overdraft.
Is overdraft interest tax-deductible for self-employed individuals?
Yes overdraft interest on a business bank account used solely for business purposes is a deductible expense for sole traders and partnerships, reducing taxable profits and therefore Income Tax and NIC liabilities.
What is the difference between an overdraft and a loan?
A loan provides a fixed amount upfront, repaid in regular instalments over a fixed term interest is charged on the full outstanding balance. An overdraft is a revolving facility you borrow and repay flexibly, and interest is only charged on the amount currently overdrawn. Loans are generally better for large, long-term borrowing; overdrafts are better for short-term working capital needs.