FORMS OF CREDIT: AN OVERDRAFT FACILITY (2)

Study Unit FORMS OF CREDIT: AN OVERDRAFT FACILITY (2)

(A) INTEREST RATES ON OVERDRAFTS An overdraft can be seen as a safety net to help an account holder manage fluctuations in his or her cash (1) ….. . If there is an existing agreement between the bank and the customer which allows the customer an overdraft and the amount by which the customer is (2) ….. is within the authorised overdraft limit, for example, £2,000, then interest will be (3) ….. at the rate agreed in the bank’s terms and conditions, for example, 15% EAR (Equivalent Annual Rate). However, if the (4) ….. balance exceeds the agreed limit then the bank may charge additional administrative (5) ….. and a higher rate of interest may apply. The main difference between APR (Annual Percentage Rate) and EAR is that APR is based on (6) ….. interest, while EAR takes compound interest into (7) …... and shows the rate of interest a customer would be charged if he or she went overdrawn for a year, allowing for the fact that interest is (8) ….. on the debt. The first overdrafts granted by banks required (9) ….. but modern overdrafts are often (10) ….. debts.

(B) SIMPLE AND COMPOUND INTEREST Simple interest applies to borrowing on debts like loans, where the money borrowed (the principal amount) is to be paid back at an agreed rate over an agreed period of time. It is an annual rate of interest that is only calculated on the unpaid balance of the principal amount borrowed and that principal amount never changes. This means that the amount of interest the customer must pay for each monthly payment cannot increase. As monthly payments are made and the balance decreases, the amount of interest paid will also decrease.

Compound interest, on the other hand, is interest that is added from time to time to the principal sum of a loan or deposit. Therefore, the interest owed on an overdraft over a particular period of time is periodically added to the principal amount owed and interest is then charged on the new principal amount total. In other words, a borrower will pay interest on top of interest. Compound interest is usual on overdrafts, which makes this a very expensive method of borrowing.

(C) WHEN AN OVERDRAFT BECOMES A PROBLEM UK debt advice charity Stepchange has recently reported that every month between 6,000 and 10,000 of the people who contact them for help have incurred unarranged overdraft fees. The charity estimates that in the 12 months before they sought debt advice, these account holders will have collectively paid approximately £1.3 million in fees. The figures also show that people with overdrafts went into the red in almost every month during the last year. The charity has called on the Financial Conduct Authority (FCA) to take decisive action to set a cap on overdraft charges and reduce the role of overdrafts in persistent problem debt.

In a survey which researched over 1000 of the charity’s clients who had overdrafts, it was revealed that, on average, they had overdrawn their current account in 11 of the previous 12 months. Recent national research has shown that around 1.7 million people are trapped in an overdraft cycle, consistently using overdrafts to meet essential and emergency costs. More than half of the people advised by the charity in the first half of the year had overdrafts as part of their unmanageable debt. This means that at least 93,000 people are struggling with overdraft debt, owing an average of £1,679 in overdrafts, in addition to their other debts. However, this number is probably a drop in the ocean when compared to the true scale of the problem. It is likely that millions of people have fallen into difficulty.

The charity advises that, in their opinion, the FCA is best-placed to balance the competing priorities of lenders and consumers and can set an effective and fair cap on overdraft charges.

The Competition and Markets Authority (CMA) has proposed that banks voluntarily set their own caps on unarranged overdraft charges. However, the ‘big four’ UK retail banks already cap their charges, some setting it as high as £90 a month, and they currently occupy 77% of the consumer market. The CMA has reported that banks make approximately £1.2 billion from unarranged overdraft charges per year, which makes it difficult to see any incentive for them to lower the cap on charges.