What is a Bank Overdraft Facility: Features, Types and Process
An overdraft facility is a financial instrument that allows customers to withdraw money or make eligible spends from their bank account even if their balance is zero. The lender, however, typically charges a fixed rate of interest on the amount utilised over and above the available balance, i.e., the overdraft amount.
Read on to understand how an overdraft facility works, overdraft types, benefits and limitations, how to apply for an overdraft and the difference between a cash credit and overdraft.
What is a Bank Overdraft Facility?
A bank overdraft facility is a form of short-term credit facility or a loan that banks offer to their customers wherein the individual can withdraw money even if their balance is zero or below zero. It is used if there is not enough balance in the account to cover a transaction or if there is an outstanding transaction resulting in a negative balance.
Bank Overdraft Example
Here is an example to understand the concept of a bank overdraft facility. Consider the following scenario:
Ramesh, a customer of bank X, has ₹4,000 in his bank account when he wants to make a transaction of ₹12,000. If Ramesh’s bank account doesn’t have an overdraft facility, he will not be able to make the full transaction (as he’ll fall short of ₹8,000). However, if he has an overdraft facility, he’ll be able to make the full ₹12,000 payment, and his bank will charge an interest on the additional amount of ₹8,000.
What are the Features of Overdraft Facility?
- Bank overdraft is a facility that can be obtained by both current and savings account holders
- An overdraft limit is assigned by the bank and is different for every customer
- The interest is, however, calculated only on the utilised overdraft amount and not the assigned limit
- Overdraft account withdrawal can be made any time up to the assigned limit
- The borrowed amount needs to be repaid within a stipulated time, usually within 12 months or as decided by your bank
- An overdraft facility usually comes with an annual fee, and you can stop this service anytime
- An overdraft facility usually doesn’t come with any prepayment penalty
How Does an Overdraft Facility Work?
When you use an overdraft facility, your bank allows you to cover expenses even if you are out of funds. You can overdraw your account through cheques, ATM transactions, debit card payments, and automatic bill payments that require to be debited from the account. The bank decides the overdraft limit, depending on the individual’s creditworthiness and relationship with the bank.
The borrower has to pay the interest along with the overdraft sum used. The applicable interest rate is calculated only on the amount withdrawn and not the total permissible amount.
Types of Overdrafts
1. Overdraft Against Salary
Many banks offer overdraft facilities to select customers who have a salary account with them. The bank OD limit could be up to 3 times the monthly account balance, subject to the bank’s terms and conditions and the account holder’s salary among other eligibility criteria.
2. Overdraft Against Savings Account
Your bank might also offer you an overdraft facility if you hold a savings account with them. The overdraft limit, the applicable interest rate and minimum EMI amount could vary from bank to bank and customer to customer
3. Overdraft Against Fixed Deposits
Some banks also offer overdraft against fixed deposits wherein eligible depositors can withdraw a certain limit, say, up to 90%, of the FD value at an interest rate that is typically 1% to 2% higher than the applicable FD rate. The overdraft repayment period could vary as per the bank and the customer’s eligibility.
4. Overdraft Against Insurance Policies
A few banks offer overdrafts against certain life insurance policies (like endowment plans or traditional policies). The maximum permissible loan-to-value ratio is usually 85% of the eligible insurance policy’s surrender value and the collateralised loan could be repaid within 6 years at an interest rate that is usually 2.50% higher than the applicable bank`’s 1-year MCLR rate, subject to the bank’s terms and conditions.
Process of Applying for a Bank Overdraft Facility
If you’re a pre-approved customer for a bank OD, you can simply withdraw more than your account balance, and your overdraft will get automatically activated. Others would be required to apply for the same through online or offline processes, subject to the bank’s terms and conditions. Customers would be required to apply separately for other types of overdraft facilities, like an OD against fixed deposits, eligible securities, property and insurance policies.
Advantages and Disadvantages of Overdraft Facility
| Bank OD Advantages | Bank OD Disadvantages |
| Good for urgent cash requirements | Interest rate, plus other charges, could be high |
| Interest rate only on utilised OD amount | OD limit could be low for certain customers |
| No additional collateral required | Only available to eligible account holders |
| Helps in avoiding cheque bounces | Might not be feasible as a long-term loan |
What is Overdraft Protection?
Overdraft protection is a service offered by some banks that ensures your transactions are covered even if your checking account has insufficient cash. But there’s usually a fee for this service. That said, the actual terms and conditions associated with overdraft protection may vary from bank to bank.
Overdraft Fee
The annual maintenance charges associated with an overdraft facility is called an overdraft fee. This is also referred to as annual review charges. The fee could be a small percentage (say 1% or 2%) of the overdraft renewal limit or a fixed amount (for example, ₹1,000 or ₹5,000), whichever higher, subject to the bank’s terms and conditions.
Final Word
An overdraft facility provides its users financial flexibility in the form of an extended credit line. A bank overdraft is a short-term financing tool that a bank account holder can use to withdraw or spend more money than what is available in their account. This credit extension can be used to cover short-term obligations or emergencies. But remember, it is a form of debt you owe to the bank that needs to be returned along with interest charges in time.
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FAQs
An overdraft facility can be obtained if there is insufficient money in an account to fund a transaction or withdrawal. In other words, it is a financial institution’s extension of credit when an account’s value reaches zero.
When you use the overdraft facility, you incur debt. You can use it for any purpose, whether to pay bills, cover debit card transactions, clear cheques or any other transaction. But remember, it is wise to use an overdraft loan only for short-term loans or emergencies.
It is wise to repay any kind of debt or overdraft on time. Typically, if money is deposited into your account, the bank repays the overdraft. You can contact your bank to understand their processes in detail.
Ideally, it would be best if you aimed to pay an overdraft as quickly as possible. But still, if you fail to pay, the bank may close your account, initiate legal action against you, or report your failure to pay, impacting your credit score.
The amount that can be overdrawn from the account is limited. The bank normally sets the overdraft limit based on the amount of working capital, the borrower’s creditworthiness, and the security given by the borrower.
An overdraft is technically a loan where you borrow a sum of money over and above your account balance that you need to repay alongwith interest within a stipulated time frame. However, unlike other loans, the interest is charged only on the utilised amount in an overdraft and not on the entire overdraft limit.
Some banks offer eligible customers an option to withdraw a portion of their FD. This is called an overdraft against FD and the maximum LTV could be up to 90% of the FD amount. The applicable interest rate could be up to 2% higher than the applicable FD interest rate.
An overdraft interest is calculated using the average daily balance method. The interest is charged only on the utilised overdraft amount and not the entire overdraft limit using a fixed interest rate or the annual percentage rate.
Overdraft limit is the maximum amount you could use as an overdraft, over and above your account balance. However, the interest would be charged only on the actual utilised amount within the overdraft limit, and not on the entire overdraft limit.
A resident Indian between 21 years and 65 years could be eligible for an overdraft facility, provided he/she is an account holder with the bank. The banks, however, may impose additional eligibility criteria like minimum income requirement among others, subject to terms and conditions.
