Are free current accounts really free?

Is it really free to use your current account? If so, how are banks making money from these services?

Key points

  • In the UK, most customers use current accounts with no monthly charge
  • The cost is recovered elsewhere, through things like low interest and overdraft fees
  • There are arguments that this means some people pay a disproportionately high amount for their banking

Although you’re probably aware of paid-for packaged bank accounts, the majority of UK banking customers use a free current account for their everyday finances.

Yet in its January 2015 report, ‘There’s no such thing as a free lunch’, auditor PriceWaterhouseCooper (PWC) branded the system of free current accounts an ‘anomaly’ and said it had led to a lack of transparency and had affected innovation and competition.

The report highlighted that, although 22% of customers hold a packaged account, the fees are to pay for the additional benefits and not the underlying banking products and, as such, are simply an extension of the concept of free banking.

When did banking become free?Pound coins and a £5 note

Banking hasn’t always been free in the UK and, in other countries, paying for banking services is very much the norm.

Until the 1980s you had to pay for services such as using cash machines, cashing cheques and even receiving statements.

In 1984, Midlands Bank changed all that by removing charges for its services and set a new banking trend in the process.

In order to compete, other UK banks dropped their charges and free banking was born.

How do banks make money now?

The way that providers make their profits is the real hot potato with free banking.

Because banks now need to find other ways to make money from current accounts, PWC says banking isn’t actually free as the banks now have to recover their revenue through other means.

“For some customers, the current account is not a free product at all - they have paid for it through overdraft charges, particularly on unauthorised borrowing, penalty fees and uncompetitive or zero rates of interest on credit balances," said the PWC report.

Consumers are relatively comfortable with the status quo, with just 20% saying they’d rather pay a fee up front to avoid additional charges

“These charges end up being disproportionately levied on specific groups of customers, including those who are more likely to find themselves in debt to their banks, or breaching their terms and conditions.

“In that sense, current accounts are a product for which the minority can end up subsidising the majority.”

The report also highlights aggressive cross-selling of other products, saying this is highlighted by a number of mis-selling scandals over the last decade.

However, the majority of customers (66%) are aware that free accounts are paid for by additional charges elsewhere, according to the report.

Yet it seems consumers are relatively comfortable with the status quo, with just 20% saying they’d rather pay a fee up front to avoid additional charges.

‘Stealth’ charges on current accounts

On 3 September, 2015, Gocompare.com checked 151 current accounts listed on the matrix of independent financial researcher Defaqto and found that 77 charged no monthly service charge. However, deeper analysis gave some insight into how these 77 accounts are paid for.

Low or no interest

An April 2011 All Select Committee Publication by the Treasury indicated that paying no or low interest was the main way free current accounts are funded, with around half of current account revenue generated this way.

Of the free accounts analysed, 66% offered no in-credit interest whatsoever and a further 13% offered 1% AER or less.

WalletOverdraft fees

Although 31% of the ‘free’ accounts could offer an interest-free overdraft, the majority of these charged for an overdraft facility with a daily or monthly fee instead, so in actual fact only 9% of accounts offered a free overdraft facility.

For a £1,000 overdraft for 30 days, only seven of the 77 free accounts could offer this free of charge.

It would cost £10 or less with nine accounts, between £10 and £20 for 18 accounts and more than £20 for 23 accounts.

The highest cost of this overdraft was £200 for one bank.

Unarranged overdrafts were, unsurprisingly, also expensive.

The example monthly cost of going into an unauthorised overdraft for 10 days for a maximum of £100 was £20 or more for 35 of the 77 accounts and between £5 and £20 on 13 accounts.

The highest unauthorised monthly charge for this situation was £100.

Penalty fees

Fifteen of the 77 free accounts levied a monthly service charge for failing to adhere to the account’s conditions, such as minimum funding, and 64 imposed an unpaid item charge for cheques, direct debits and standing orders that couldn’t proceed due to insufficient funds.

Service fees

For customers needing a duplicate statement, 69 of the free accounts charged for the service, and 28 charged to give a copy of a cheque.

Sixty-six of the accounts charged for a banker’s draft (which you might need to pay an organisation that cannot accept a personal cheque) and 59 charged for a banker’s reference (for instance, if your landlord asks for one).

The argument against free current accounts

It’s not just PWC that has noted the impact on competition of free current account banking.

Did you know...?

  • According to a PWC report 62% of people wouldn't be willing to pay anything for their bank account

In the April 2011 All Select Committee Publication by the Treasury, a number of challenger banks gave their views on whether the free current account model had been a barrier to them as new entrants to the sector.

Virgin Money argued that free banking meant that all banks seemed the same to consumers, giving them no obvious financial incentive to switch accounts.

“Free banking makes it very difficult for new entrants to the personal current account market," said Virgin Money. "New entrants are not able to compete by offering lower prices (than zero) or by innovating with simpler, lower-cost products.”

Tesco Bank said that new banks were “placed at a further disadvantage by the ability of incumbent banks to offer attractive rates to new customers, which they pay for by giving very low rates to their existing customers”.Why midata will reform the current account market

Metro Bank, however, took an alternative view. It pointed out that an Office of Fair Trading report had noted that only 7% of people moved current account because of the rate and 93% were driven by service and convenience.

It thus argued that banking competition could be driven by service quality rather than simply by interest rates.

The future of free banking

With the PWC report finding that 62% of customers wouldn’t be willing to pay anything at all for their current account, an industry move towards paid-for current accounts would, it seems, require a major shift in consumer thinking.

“In the short term, it is difficult to see how a bank would remove its free banking product - the risk of being left on its own would pose a considerable risk of losing customers and business,” the PWC report said.

It suggested regulators could intervene because free banking doesn't support innovation and competition, but concluded this was unlikely due to “customer sentiment”.

In October 2015, the Competition and Markets Authority published its Retail Banking Market Investigation, in which it stopped short of recommending an end to the free banking model because it found that it wasn't distorting competition.

"While free if in-credit (FIIC) reduces to some extent awareness of the costs (direct and indirect) that customers are incurring, we have not found that the FIIC model is contributing to low switching rates," the investigation said.

But PWC believes the banking industry itself will change the free banking model in time.

“The most likely outcome is the gradual decline of the free-if-in-credit model,” it said. “There will be a move towards tiered pricing and the retention of a very basic, free product. Better transparency between service, costs and fees can only help to address the trust challenge.”

By Derri Dunn