What is a Bank Overdraft and How to Apply for It
An overdraft is a form of short-term credit facility or a loan. It is a facility 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.
Read on to understand how overdraft works, overdraft types, benefits and limitations, how to apply for an overdraft and the difference between a cash credit and overdraft.
How Does an Overdraft 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 checks, 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 The applicable interest rate is calculated only on the amount withdrawn and not the total permissible amount.
Overdraft Example
Here is an example to understand the concept of bank overdraft. Consider the following scenario:
Mr. X makes a debit card transaction of Rs.12,000. The current balance available in the account is Rs.8,000, which means Mr. X is short Rs.4,000. If X has an overdraft facility available, the bank would ideally settle the remaining balance of Rs.4,000. However, Mr. X will be charged interest on the Rs.4,000 overdraft.
How to Apply for an Overdraft?
You can apply for an overdraft with your existing bank via banking apps, online banking platforms, or by visiting your nearest branch. When applying for a bank overdraft facility, you will need to provide all the necessary details and documents.
If your application or request is approved, you will be assigned an overdraft limit which is different for every account holder. This limit depends on your relationship with the bank, credit score and credit history.
Types of Bank Overdrafts
There are two types of overdrafts.
1. Authorised Overdraft
In this type of bank overdraft, through an arrangement, both parties agree to an overdraft limit that the account holder can use for transactions and payments. There is also a daily, weekly or monthly service fee that varies from one bank to another.
In this type of bank overdraft, the bank account holder has spent more than his available balance without any advance arrangement or authorisation from the bank. An unauthorised overdraft can also occur when the account holder has spent more than his overdraft limit.
Features of Bank Overdraft
The following are the features of a bank overdraft:
- Bank overdraft is a facility that can be obtained by both current and savings account holders.
- Interest is calculated only on the utilised amount and not the assigned limit.
- The overdraft limit is assigned by the bank and is different for every customer.
- Overdraft account withdrawal can be made any time up to the assigned limit.
- The borrowed amount needs to be paid in a stipulated time, usually within 12 months or as decided by your bank.
Always remember that the overdraft facility has an annual cost, and you can stop this service anytime.
How to Protect an Overdraft?
Overdraft protection is a service offered by many banks that ensures your transactions are covered if your checking account has insufficient cash.
However, a fee may be associated with the same. Ensure to read all terms and conditions for overdraft protection, as they may vary from one bank to another.
Advantages of Bank Overdraft
The advantages of bank overdraft are mentioned below:
- Aids in Managing a Company’s or an Individual’s Finances
Overdraft loan facilities can be used to address the cash flow of businesses or individuals. Account holders can sign cheques for their clients or make purchases beyond the available funds in their accounts using the overdraft loan facility. This can be extremely beneficial in case of emergency payment to vendors etc.
Also, overdrafts can be very helpful if a payment or bill is overdue and you don’t have enough balance in the account. The overdraft can be used to settle any outstanding transaction. - Can Prevent Cheque Bounces
Bounced cheques can harm your credit history. Bounced checks can be avoided with a bank account overdraft. The bank pays for the amount if there are insufficient funds to clear the cheque. - Time-Efficient
When concerning short-term cash requirements, bank overdraft is easy to obtain and requires minimal paperwork. There is no requirement for collateral. In other words, if used smartly, an overdraft facility can be a convenient option. - Interest is Calculated Only on the Withdrawn Amount
You don’t have to pay the interest on the total assigned limit. Interest is paid only for the used overdraft amount. For example, if you have an overdraft of Rs.10,000, then you pay interest only on this amount and not your overdraft limit.
Disadvantages of Bank Overdraft
The following are the disadvantages of bank overdraft:
- Overdraft loan arrangements can be very expensive, considering that the fees and interest rates levied can be very high.
- Overdraft facility is only offered to bank account holders.
- Your bank can charge extra fees if you exceed the overdraft limit without the bank’s authorisation.
- The sanctioned limit depends on the applicant’s credit history and financials.
- A bank overdraft facility is not suited for long-term financing.
Differences Between Cash Credit and Overdraft Account
Cash credit and overdraft accounts are often considered similar but carry a few significant differences. Let’s take a look below:
| Cash Credit | Overdraft Account | |
| Definition | Cash credit is a short-term financial tool or source of finance that is offered to businesses by banks or financial institutions | Overdraft is a facility provided to individuals and businesses wherein the account holder can withdraw an amount in excess to their balance. |
| Uses | It should be used for business. | It can be used for any purpose. |
| Interest Rate | This type of extension has lower interest rates. | Typically, this facility calls for higher interest rates. |
| Limit | The loan amount depends on the volume of stocks and inventory of the corporation. | The loan amount depends on the financials, security deposits and credit history of the applicant. |
| Duration | A cash credit loan is available for a minimum of 1 year. | An overdraft can be availed for a shorter term. It can be monthly, quarterly or for a maximum of 1 year with a yearly renewal option. |
| Account Required | A new account has to be opened to avail of this facility. | Overdraft is generally offered to customers with existing bank accounts. |
Final Word
An overdraft 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.
FAQs
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
