Understanding credit cards and overdrafts

Credit card and overdraft rates have hit record highs in the UK. We’re hoping to help explain the key differences between the products to help you get a better understanding of how they work, what they cost, and the main benefits and risks.

In this article, we dive into these two borrowing options which are becoming more popular methods of obtaining credit.

Understanding credit cards

A credit card allows you to spend money up to a pre-set limit that has been agreed with your bank. When you apply for a credit card your financial institute will carry out a hard credit check which will assess your credit file and let other lenders know that you have applied for credit. With credit cards, you must ensure that you are aware of your own card’s terms and conditions, interest rates, fees and penalties as not all cards are the same.

Despite interest rates being at their highest level since June 2006 typically charging an average of 23% APR, consumer borrowing (including car finance and personal loans) has not shown signs of slowing down. Borrowing levels have increased to the highest level since July 2022. Last year purchases made via credit card or a “buy now, pay later” company accounted for a third of all purchases made in 2022 indicating just how frequently these are used.

How credit cards work

If you make a purchase on your credit card then each month you’ll get a bill for a ‘minimum repayment amount’ which should always be paid. The ‘minimum repayment’ value varies depending on how much you have spent on your card. It represents the very minimum amount you need to pay to meet your repayment obligations. If you are in a financial position to make a repayment that is higher than your minimum repayment amount, it is better to do so as it will save you money in interest and help you to repay the borrowing sooner.

Some people use credit cards even when they have the funds available for their planned purchase. They pay using their credit card and then repay the balance almost immediately, meaning no interest is charged on the purchase. This is due to credit cards being protected for the majority of purchases over £100 and up to £30,000. In a number of circumstances Section 75 of the Consumer Credit Act, covers you in the unfortunate event of something going wrong with your purchase thus potentially providing additional protection from your card provider.

Find out more information on ‘Section 75’ by visiting the Financial Ombudsman Services website.

Why your credit score matters

When applying for credit having a higher credit score can increase the probability of you having a successful application. Your credit score can also have an impact on the interest rate a financial institute offers you due to ‘Representative APR’. The term ‘Representative APR’ means that the lender is making a reasonable assumption that at least 51% of applicants will be offered the rate advertised by the financial institute. The remaining 49% of applicants may be charged a higher APR that typically differs from the headline rate.

Unfortunately for applicants unless you have been offered a pre-approved rate, you do not know what interest rate you will be charged until your credit file has been assessed and a hard credit check has been completed. Many credit cards offer representative APR’s so it is worthwhile understanding what this could mean for you.

Managing your repayments

Unlike a loan, credit cards have no repayment end date. By making the regular minimum monthly repayment, there is a chance you may not be repaying much of the balance owed, but instead making repayments mainly towards the interest charged. In these circumstances, it is important to make plans to repay this capital as soon as you can to reduce the amount you are repaying in interest.

Before making a credit card purchase (if you don’t have the funds ready immediately), ensure you will have the means to make sufficient payments towards your credit card balance. Forward planning can help to make credit card debts manageable.

Key points to keep in mind:

• You need to be at least 18 to apply for a credit card. With some cards, the minimum age is 21
• It is likely to cost you more to withdraw cash from a credit card due to its fees. If you do withdraw cash on your credit card, you’ll usually be charged a fee plus interest (at a higher rate) daily from the day you take your cash
• Having repeated hard credit searches due to regular credit applications negatively impact your credit score
• If your application is accepted, the card provider will give you an agreed credit limit. Going over this limit can lead to you receiving financial penalties
• If you miss a payment or go over your credit limit you could severely damage your credit score
• Some credit cards are expensive to use abroad however this depends on the card you have
• Credit cards are accepted at more places than debit cards and prepaid cards
• The faster you repay your credit card balance, the less interest you will pay
• Make sure you understand the terms and conditions and key product information of your credit card.

Understanding overdrafts

In 2020 the Financial Conduct Authority (FCA) introduced major changes affecting how banks can charge for overdrafts. Those offering overdraft facilities charge around 19% – 40% or more in interest.

There are two different types of overdrafts, unarranged and arranged. However, you should be aware that;

• An arranged overdraft is one that you’ve agreed with your bank. It’s subject to pre-agreed interest and fees.
• An unarranged overdraft is when you have exceeded your arranged limit with your bank, or you have overspent on your current account and used an overdraft facility which has not been agreed for you. This can potentially impact your credit file.

Key points to keep in mind:

• There is no end date for paying off your overdraft.
• The Financial Conduct Authority found that many people underestimate how much they use their overdrafts.
• Your bank can withdraw or reduce your overdraft at any time, without notice.
• Your credit rating can affect whether a bank will offer you an overdraft. This means if your credit rating is poor, you could struggle to be approved for an overdraft.
• If you frequently exceed your overdraft limit, or you owe too much on your overdraft, your credit rating can be affected. This can mean you could be less likely to be accepted for other forms of borrowing, such as applying for a mortgage.
• Your bank may write to you about your overdraft and it is important to read their letters to ensure you do not miss any important information regarding your account.
• If you change banks, there is no guarantee your pre-agreed overdraft limit will be matched by your new account provider.
• The Financial Conduct Authority estimates that you are 24% less likely to receive unarranged overdraft charges if you use a mobile banking app and text alert service.

The above article introduced the topic of credit cards and overdrafts providing you with some important information which might help you to better understand different types of credit. We recommend that you speak to a Financial Adviser if you want independent advice on your financial situation.

If you are struggling with making credit card or overdraft repayments, please visit our Managing Debt webpage or contact one of the services below.

• StepChange Debt Charity or call 08001381111
• National Debtline or call 08088084000
• PayPlan or call 08002802816
• Debt Advice Foundation or call 08006226151

Please note: All services listed above are free to use and offer varying support.

Written by,

Benjamin Kirkman

Marketing Officer