A 2 year government investigation by the Competitions and Markets Authority (CMA) into overdrafts has found that the current model has failed consumers. And in a way the system is also failing for the banks.
Consumers are paying out over £3bn a year in charges, but banks are in a bind - how do they provide excellent customer service and products for free to people in the black without charging fees to those in the red?
The report is very thorough. You can read all 766 pages here. Don’t fancy 766 pages of confusing acronyms and technical terms? Don’t worry - we’ve read it for you and are happy to share our thoughts on this blog. While some of the findings were expected, many were surprising, and a few were outright shocking.
Almost half of us, 23m adults in UK, have overdrawn our bank account at least once in the last year. Half of these customers use the overdraft within the limits approved by their banks. That’s the end of the good news.
Unfortunately, the rest of us go into what the banks call "unarranged overdraft". This is where things get expensive. Very expensive. The FT reported that unarranged overdraft fees are upto 7 times more expensive than the payday loans. Some banks charge up to £6 a day for an unarranged overdraft. Most of us would never go near a payday loan company yet we accidently slip into something worse.
Out of all of us who overdraw, almost a third do not pay any significant overdraft fees. The lucky few. The majority 15m of us in the UK get charged fees which add up to £3bn.
On an average we pay £200 in overdraft charges a year. As with most things there is a distribution of users that ranges from the light users who typically pay £45 a year, to the heavy users who pay more than £600.
And when we go past our bank limit into unarranged territory, we pay extortionate amount of fees. Of the £3B, £1.2B was from unarranged charges.
Overdraft is often the first credit product we use after finishing education. On the face of it, it sounds like a great service. We develop spending habits on debit cards, spending within our means. And we can pay for occasional rainy day using our overdraft. Overdraft becomes a problem when we then get used to it. We slip into a long term habit of going overdrawn.
The younger we are, the more we use overdrafts - not a huge surprise. What is worrying though is how much of that is unarranged with high fees. With limited credit history, young people are not given decent credit limits. This traps them in a monthly downward spiral cycle.
Overdrafts are convenient & frictionless. So is spending on contactless cards and smartphones. When we go overdrawn there is no friction. When it is taken back automatically out of our next salary there is no friction. When the fees are taken at month end there is no friction. No alerts. Nothing to see here. Move along.
The CMA study took a large sample of 2000 overdraft users and asked them about their usage. When users are asked how many months they used overdraft in a year they significantly underestimate their use.
Over 40% of consumers who used overdrafts did not think that they did. While 28% used overdraft every month in the last year, only 11% knew that.
Similarly when asked about how much we thought we paid for overdraft, most of us thought we paid far less than we actually did.
These issues around awareness of usage are particularly acute for unarranged overdraft users. Around half of these folks did not believe that they had paid unarranged fees. That’s £600m the banks took off people without them even realising.
Overdraft works reasonably well for a small set of users with low to medium usage. People that spend within their limits and keep an eye on their accounts. However most of us, even in the low use group, pay fees because we don’t have time to keep an eye on our daily bank balance.
Banks do not normally remind us when we go overdrawn. A Financial Conduct Authority (FCA) study found that users who signed up for mobile alerts reduced their unarranged charges by 24% This would cost banks hundreds of millions a year so no wonder they are not too keen on telling us.
For those who use overdraft more than 3 weeks in a month, the overdraft is an unlimited term interest only loan. The entire amount is taken when you are paid your salary and within days you are back into building up this months debt, making it hard (or impossible) to pay back the original amount because all you ever pay off is last months charges.
And the interest cost is high. Because of the super easy convenience of an overdraft, banks charge a premium. One of the most expensive form of credit offered by the high street banks. For a vast majority of the overdraft users, the bank overdraft is a badly designed product.
It is reasonable to assume that in well functioning markets, badly designed products like overdrafts should be fixed through competition. So why couldn't a better solution come from within the banking sector? Because their hands are tied.
Banking in the UK evolved into, and is now stuck in, a ‘Free-if-in-credit’ service. Retail banking is free for consumers who have deposits - these include your current accounts, all direct debit payments, and cash machine access. All vital services for modern life. All free to use. Hooray!
So when the CMA took a look at what customers pay banks for these great services, 92% of all charges came from, guess who?, the overdraft users. The only people who pay for retail banking are the ones who can not afford it.
It is then not hard to figure out why banks, with high operation costs and pressure to make a buck, have no incentive to solve this issue.
If banks try to solve it through charging fair fees to people in the black they will promptly lose those customers overnight. So banks are stuck. It’s easy to blame them, but all of us like our free bank accounts and cards.
As we’ve discovered, the answer to the downward cycle of overdraft fees has to come from outside the banking sector. My colleagues and I here at Updraft have decided to do something about it. To design a good product fit for the modern frictionless age.
We’ve concluded that the best way to solve the problem is to replace overdrafts with a much cheaper product, and not rebuild the expensive parts of banking which already work well. We won’t be running current accounts. We won’t be sending out colorful bank cards. We’ll simply plug into your existing bank account and lift you out of the debt cycle.
The app we are building connects to your existing bank account using the new OpenBanking APIs. It will then give you the services you need that your bank will not;
a) Updraft uses AI to predict patterns in your spending and alerts you BEFORE you overspend. You’ll probably still go over but at least you’ll be aware of it and might skip a few trips to buy coffee.
b) Updraft replaces your overdraft with a low interest loan. As we’ve seen - unarranged overdrafts can cost £6 a day. We’re designing Updraft’s version to cost only 6p.
By cutting your bank charges and being just that little bit more aware of overspending, we hope you will float gently out of debt in months.
Help us build a useful & ethical replacement to bank overdrafts by joining our preview program.