How Is Overdraft Interest Calculated?

The calculation is daily

The single most useful thing to know: overdraft interest is worked out on the balance at the end of each day, not on the largest amount you reached and not on a monthly average.

Each day the bank looks at how much you are overdrawn at close of business, applies one day's worth of the annual rate, and files that amount away. At the end of the charging period it adds up the daily amounts and takes the total.

Two consequences follow immediately, and both are practical.

• Duration matters as much as size. Being 1,000 down for two days costs roughly what being 100 down for twenty days costs. Same total, very different-feeling situations.
• Paying in early in the day, or a day earlier, genuinely reduces the charge. Every day removed from the count is one day's interest removed.

The formula, with a worked example

For one day:

daily interest = overdrawn balance × (annual rate ÷ 365)

Some banks divide by 365 every year and some use 366 in a leap year; the difference is immaterial to the point. Take an annual rate of 39.9% and an account that is 400 overdrawn.

• Daily rate: 0.399 ÷ 365 = 0.001093, or about 0.109% per day.
• One day at 400 down: 400 × 0.001093 = 0.44.
• Thirty days at 400 down: about 13.11.

Now change only the pattern, not the rate. Suppose instead the account is 400 down for ten days, back to positive for ten, then 400 down for another ten:

• Twenty chargeable days rather than thirty: about 8.74.
• Same rate, same peak balance, a third less interest.

This is the arithmetic behind the standard advice to move payday or shift a direct debit date. It is not a trick; it removes days from the count.

Why the charge arrives monthly

Daily amounts are small and awkward, so banks accumulate them and debit the total once per charging period, usually monthly. Two things follow that catch people out.

The charge lands after the borrowing. The interest debited this month is for last month's balances. So the month you finally clear the overdraft, one final charge still arrives — for the period before you cleared it. People often think an error has occurred. It has not.

The charge itself can push you overdrawn. If the account is at or near zero when the interest is taken, the debit can put you below it, which starts a fresh accrual and, if you have no arranged facility, may be an unarranged overdraft you never chose.

Most banks will tell you in advance what the charge will be and when it will be taken. That notice is worth reading precisely because of the second point.

Interest on the interest

When the monthly interest is debited, it becomes part of the account balance. If the account is overdrawn, the debt is now larger by exactly that amount — and tomorrow's daily calculation runs on the larger figure.

That is compounding, and in an overdraft it is easy to miss because there is no statement drawing attention to it. The practical result is the characteristic behaviour of a neglected overdraft: a balance that grows without anyone spending anything.

It also explains something people find puzzling — an overdraft they have not used for months, on an account they have not touched, that is slightly deeper every time they look. Nothing is wrong. The product is doing exactly what it was described as doing.

EAR is not APR

Overdrafts in the UK are quoted as an EAR — Effective Annual Rate. Credit cards and loans are quoted as an APR — Annual Percentage Rate. They are not the same measure and cannot be compared directly.

• EAR expresses the interest rate including the effect of compounding, and includes interest only. It does not include fees.
• APR is designed to express the total cost of credit, so it folds in certain compulsory fees alongside interest.

The reason overdrafts use EAR is straightforward: an overdraft has no fixed amount and no fixed term, so the assumptions APR relies on do not exist. There is nothing to amortise.

The practical consequence is that an EAR of 39.9% and an APR of 39.9% are not statements about the same thing, and putting an overdraft next to a credit card on the strength of those two numbers is comparing different measurements. Compare the actual money instead: work out what each would cost for the amount you actually borrow, for the number of days you actually borrow it.

Buffers and interest-free amounts

Several accounts include a small amount you can go overdrawn without being charged. Names vary — buffer, formal buffer, interest-free amount. Typical sizes are small, often somewhere between 15 and 100 depending on the account.

Three things about buffers are worth knowing:

• They are usually all-or-nothing at the edge. Go one unit past the buffer and interest is generally charged on the whole overdrawn balance, not just the excess. Check your own terms, because this varies.
• They are not a facility. A buffer does not stop you being unarranged if you have no agreed limit; it only affects what you are charged.
• Student and graduate accounts often have large interest-free limits that shrink on a schedule after graduation. Those schedules are set at the start and are easy to forget, and the transition is a common route into an unexpectedly charging overdraft.

Why two people pay different amounts on the same rate

Same bank, same advertised rate, very different charges. The variables that actually move the number:

• Days below zero, which is the dominant factor and the one most within your control.
• How deep, day by day — not the peak, the daily closing figures.
• Whether an interest-free buffer covers the typical dip. Somebody who dips 20 with a 25 buffer pays nothing; somebody who dips 30 pays on the lot.
• Whether the balance ever returns to positive. An account that crosses zero every payday accrues on far fewer days than one that never does.
• Timing of large direct debits relative to income, which decides how many days each month begin overdrawn.

None of these are visible in the advertised rate, which is why the rate alone predicts very little about what an overdraft will cost a particular person.

Where this doesn't apply

If your account charges a flat fee each time a transaction takes you below zero, none of the arithmetic above describes your cost. In that structure the amount and duration are largely irrelevant — what matters is the number of items. Five small transactions on one bad day can cost several times more than one large transaction of the same total value, and being overdrawn for a month costs no more than being overdrawn for an hour.

That is the dominant US structure, and it inverts the advice. Under interest, you minimise days and depth. Under per-item fees, you minimise the number of transactions that cross zero — which usually means checking the balance before a run of small payments, not after.