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 an Overdraft?
An overdraft is a credit facility linked to a current account that allows the account holder to borrow money when the account balance falls below zero. The bank sets the permitted borrowing limit, interest rate and repayment conditions. Interest normally depends on the amount borrowed and how long the account remains overdrawn.
For example, a customer has £200 in a current account and makes a £500 payment.
If the customer has an available overdraft facility, the bank can fund the £300 shortfall.
The resulting account balance is:
£200 − £500 = −£300
The customer now owes the bank £300, plus any applicable overdraft interest.
What is an overdraft facility?
An overdraft facility is an agreement allowing an account holder to borrow up to an approved limit through a current account.
The facility normally specifies the borrowing limit, applicable interest rate, charges and conditions under which the bank may require repayment.
What are the main features of an overdraft?
| Feature | How the overdraft works |
|---|---|
| Credit limit | The bank sets the maximum authorised borrowing amount. |
| Interest | Interest normally applies to the amount borrowed. |
| Repayment | Money paid into the account reduces the overdrawn balance. |
| Availability | Available credit can generally be reused within the agreed limit. |
| Duration | Overdrafts are commonly designed for short-term borrowing. |
| Credit assessment | Banks assess eligibility before approving an arranged facility. |
| Withdrawal | The bank may reduce or withdraw the facility under its terms. |
An overdraft differs from a standard loan because the borrower does not receive the full approved amount as a separate lump sum.
Instead, the account holder accesses the facility when the current account has insufficient funds.
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
How Does an Overdraft Work in a UK Bank Account?
A bank overdraft works by allowing payments to exceed the money available in a current account. The bank funds the resulting shortfall within the permitted borrowing limit. Incoming payments reduce the outstanding balance automatically, while interest normally accrues on the amount borrowed for each day the account remains overdrawn.
Step 1: The bank approves an overdraft limit
Suppose your bank approves an arranged overdraft of £1,000.
Your current account contains £500.
Your available funds are:
| Component | Amount |
|---|---|
| Current account balance | £500 |
| Available arranged overdraft | £1,000 |
| Total available funds | £1,500 |
The overdraft facility provides access to additional borrowing. The £1,000 is not additional income or personal savings.
Step 2: You spend more than your current balance
You make a payment of £800.
Your account balance changes from £500 to −£300.
You have borrowed £300 through your overdraft.
Step 3: Overdraft interest accrues
The bank calculates interest on the outstanding overdrawn balance according to the account’s interest rate and charging method.
If your account has an interest-free overdraft allowance, the bank applies the relevant account conditions before calculating the charge.
Step 4: Incoming money reduces your borrowing
You receive £600 into your account.
The overdraft balance changes:
−£300 + £600 = £300
You now have a positive account balance of £300.
The £300 overdraft borrowing has been repaid automatically.
Any interest already incurred remains payable under the bank’s charging schedule.
Arranged vs Unarranged Overdraft: What Is the Difference?
An arranged overdraft is borrowing agreed with your bank before you use the facility. An unarranged overdraft arises when the bank allows a payment that takes your account below zero without an agreed facility or beyond your approved borrowing limit. Both forms involve borrowing, but the approval and account conditions differ.
What is an arranged 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.
What is an unarranged 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.
Arranged and unarranged overdrafts compared
| Feature | Arranged overdraft | Unarranged overdraft |
|---|---|---|
| Prior bank approval | Yes | No |
| Agreed borrowing limit | Yes | No prior approval for the excess |
| Interest | Based on agreed account terms | Subject to applicable FCA pricing rules |
| Payment approval | Usually available within facility conditions | Bank may decline the payment |
| Credit assessment | Normally completed before approval | An unarranged balance can create additional credit concerns |
| Recommended use | Planned short-term borrowing | Should not be relied upon as planned credit |
For personal current accounts, the Financial Conduct Authority (FCA) prohibits banks from charging a higher interest rate for an unarranged overdraft than the relevant arranged overdraft rate under its applicable pricing rules.
However, the FCA rules do not require every bank to charge an identical rate for arranged and unarranged borrowing. A bank may charge less for unarranged borrowing or waive unarranged interest altogether.
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.
What Is a Business Overdraft Facility in the UK?
A business overdraft is a short-term borrowing facility attached to a business current account. The bank agrees a borrowing limit that allows the business to make payments exceeding its available cash balance. Business overdrafts commonly support working capital, seasonal expenses and temporary gaps between customer receipts and supplier payments.
A business overdraft can help a company finance ordinary operating expenditure without taking out a separate fixed-term loan for every short-term cash requirement.
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
How Do You Apply for an Overdraft in the UK?
You can normally apply for an arranged overdraft through a bank’s online banking service, mobile application or banking team. The bank assesses your financial circumstances, credit history and repayment capacity before deciding whether to approve the facility. Approval and the available borrowing limit are not guaranteed.
How to apply for a personal overdraft
The normal application process involves:
-
Checking whether your current account offers an arranged overdraft.
-
Reviewing the bank’s eligibility criteria and indicative interest rate.
-
Selecting the borrowing limit you want to request.
-
Providing any additional information required by the bank.
-
Completing the lender’s credit and affordability assessment.
-
Reviewing the approved limit, EAR and facility terms.
Some banks provide an initial eligibility checker that does not affect your credit score. A full application may involve a credit search.
For example, HSBC offers an overdraft eligibility-checking facility and explains the distinction between eligibility checks and a full application.
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.
What is an overdraft on a bank account?
An overdraft is a borrowing facility that allows a current account balance to fall below £0. The bank provides the money needed to cover eligible payments. Interest normally applies to the amount borrowed, and the account holder must repay the outstanding balance under the agreed conditions.
How does an overdraft work when you get paid?
Money paid into an overdrawn account normally reduces the outstanding overdraft automatically. For example, if your account balance is −£400 and you receive £1,500 in salary, the account balance becomes £1,100. Any overdraft interest already incurred remains payable under the account terms.
Can you withdraw cash using an overdraft?
Yes, an arranged overdraft can normally fund eligible cash withdrawals where the bank permits them. Cash withdrawn beyond the available positive balance becomes overdraft borrowing. The applicable overdraft interest and any separate cash-machine charges depend on the account and withdrawal terms.
Is overdraft interest tax deductible for a sole trader?
Yes, qualifying interest incurred on borrowing used for business purposes can normally be claimed when calculating taxable trading profits. Personal borrowing costs are not deductible simply because the account holder operates a business. A mixed-use overdraft requires appropriate evidence and allocation of the business-related interest.
Does an overdraft affect a mortgage application?
Yes, overdraft usage can influence a mortgage lender’s credit and affordability assessment. However, having an arranged overdraft does not automatically prevent mortgage approval. Lenders assess the outstanding balance, repayment history, account conduct, income and other financial commitments.
Can you get a business bank account with an overdraft?
Yes. Some UK banks provide business current accounts with overdraft facilities for eligible customers. Approval depends on the lender’s requirements, including the business’s financial position, creditworthiness and expected repayment capacity. An overdraft is not automatically included with every business bank account.
How long can you remain overdrawn?
The permitted borrowing period depends on the facility agreement. Many overdrafts do not have fixed monthly repayment instalments, but banks can review limits and require repayment under the applicable terms. Remaining overdrawn for an extended period can increase borrowing costs and create financial pressure.
Get Professional Support With Business Cash Flow and Overdraft Accounting
An overdraft can provide short-term funding for a UK business. However, the facility’s financial impact extends beyond the interest rate.
Accurate bookkeeping should distinguish borrowed funds from trading income, record finance costs correctly and reflect the outstanding liability in the business accounts.
For sole traders and limited companies, the tax treatment of overdraft interest also depends on the purpose of the borrowing and the applicable HMRC rules.
At AccFirm, we support UK businesses with bookkeeping, financial reporting, tax calculations and cash-flow management.
Our small business accountants can help business owners maintain accurate financial records and understand how overdraft borrowing affects their business accounts.
If you operate as a sole trader, our sole trader accountants can also assist with allowable expenses, Self Assessment and the correct tax treatment of business finance costs.
For incorporated businesses, our limited company accountants provide support with statutory accounts, Corporation Tax and ongoing financial reporting.