Exploding Overdraft Interest Rates: Protecting Yourself from the Financial Downward Spiral

Small account loss, big costs: Many banks are turning the overdraft interest rate screw hard.

For many of us, the idea is tempting: simply flying on vacation at short notice, paying for unexpected car repairs without worrying about it, or shopping carelessly without paying attention to the account. In such moments, the overdraft facility is the savior in financial distress. But the supposed financial solution can be more expensive than we imagine. Overdraft interest rates have exploded recently, making both experts and consumers sit up and take notice.

Rapid increases and causes

According to Heike Nicodemus from the magazine Financial test According to Stiftung Warentest, overdraft interest rates have increased at a breathtaking pace. Since the end of 2022, they have increased by an average of more than 2 percentage points, and at the beginning of the current month many credit institutions increased their interest rates again. The average interest rate for tolerated overdrafts on current accounts is now around 12 percent (as of October 6, 2023), compared to 9.94 percent at the end of 2022.

“Many credit institutions upped the ante on October 1st,” reports Nicodemus.

She explains that most people who have a checking account can, with the bank’s permission, usually overdraw it up to a set amount and must pay interest to the bank. The interest for the overdraft is due for every euro and is calculated on a daily basis. The basis for the calculation is the amount by which the account was overdrawn, the number of days the account was in the red and the current interest rate. “The banks offer a service and they charge money for it,” explains Nicodemus. But why these drastic increases?

The mechanisms of overdraft interest

The increase in overdraft interest is mainly due to the interest rate increases by the European Central Bank (ECB). The ECB has carried out a series of ten interest rate hikes since July 2022 to counteract ongoing inflation. This increase in the central bank’s key interest rates has a direct impact on the banks’ overdraft rates. Most of these interest rates are linked to reference interest rates, such as the ECB’s key interest rate or the three-month Euribor. If these reference interest rates rise, the overdraft interest rates follow with a time lag.

Consumers in a quandary

Especially in times of rising living costs, the overdraft could appear to be a lifeline. According to a YouGov survey for Postbank, around 17.2 percent of those surveyed can hardly cover their living costs due to inflation. However, you should be careful not to overuse your overdraft facility, as a frequently used overdraft facility can lead to a vicious financial circle.

Fight for upper limits

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Given interest rates of up to 15 percent on loans, the discussion about capping overdraft interest is gaining momentum. Consumer protection ministers of the federal states are in favor of this, while banks and savings banks reject government intervention and point to the highly competitive German banking market.

“I think the more than 15 percent that we found in 18 account models is really crazy,” says Heike Nicodemus from Stiftung Warentest.

The smarter alternative

However, there are alternatives to the overdraft. An installment loan can be significantly cheaper, especially if you use the overdraft frequently. On average, an installment loan can save around half the interest costs of an overdraft facility. So before you get carried away by high overdraft interest rates, you should carefully check whether refinancing with the help of an installment loan is the smarter option.

“If you regularly use the overdraft facility, you should consider whether it makes sense to refinance your debt using an installment loan, which costs around half as much on average,” advises Heike Nicodemus from Stiftung Warentest.

With these 10 points you can escape the debt trap:

• Create a budget: Start with a clear budget. List all income and expenses to get a better understanding of your financial situation.
• Build up emergency reserves: Create an emergency reserve, for example in an interest-bearing current account, that covers around three to six months’ salary. This provides financial security in unforeseen situations.
• Save before you buy: Before you make any major purchases, like a car or furniture, save up for them. This reduces the need for loans.
• Live within your means: Avoid spending more than you earn. Make sure your expenses don’t exceed your income.
• Use credit cards wisely: Use credit cards responsibly and pay monthly bills in full. High credit card debt can cause serious financial problems.
• Choose loans carefully: If you need a loan, choose it carefully. Compare interest rates and conditions and make sure you can pay the installments in the long term.
• Check your budget regularly: Update your budget regularly to make sure it fits your current financial situation.
• Avoid impulsive purchases: Think before making large or expensive purchases. Impulsive purchases can lead to imprudent debt.
• Set financial goals: Define clear financial goals and plan how you will achieve them. This helps you stay on track and avoid debt.
• Seek help with debt early: If you realize that you are facing debt, seek professional help early on. Solving debt problems is often easier if you act in a timely manner.

Conclusion: Financial decisions in your own hands

Everyone has the choice and the opportunity to actively shape their financial situation. With a better understanding of the pros and cons of overdrafts, young people can make informed decisions and stay in control of their finances. While the overdraft facility is a simple solution to short-term financial bottlenecks, the ever-increasing overdraft interest rates should encourage us to think critically about our financial future and consider sustainable alternatives.