Overdraft facility is a credit facility offered to account holders allowing cash withdrawals even if the account balance is zero or negative. It acts as a safety net during unforeseen financial situations providing a pre-approved credit line that extends beyond your account balance.
However, before utilizing this financial tool, it’s crucial to understand its functionality, implications, and responsible management.
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What is Overdraft?
Overdraft is an extended line of credit offered by banks where individuals or businesses can withdraw money from a current or savings account even if the account balance is at or below zero. Withdrawing cash beyond that point means the account is overdrawn.
An overdraft basically allows the account holder to withdraw from the account even when there is no cash available. It is a form of short term credit offered by banks to help businesses in times of cash crunch.
Overdrafts can be triggered by various events, such as writing a check that exceeds your balance, using a debit card for a purchase that puts you in the negative, or automatic payments like bills or subscriptions exceeding your account balance.
The overdraft limit offered to each account holder depends on factors like credit score, relationship with the bank, account balance, etc. Banks charge interest only on the drawn amount, not the total sanctioned limit. Since OD (Overdraft) comes with interest charges and fees, it must be used responsibly.
Features of Overdraft
No Collateral Required
Unlike traditional loans that may require assets to be pledged as collateral, most overdrafts do not require any security. This is very useful for small businesses or startups that may not have assets to offer as collateral but might still need quick access to funds in case of emergencies.
Overdraft Limit
The overdraft limit is the maximum amount a business can borrow from the bank. It is generally determined based on the company’s creditworthiness, transaction history, and relationship with the bank. Businesses should always ensure they understand their overdraft limit, as exceeding it may result in higher interest charges or additional fees.
Penalty and Fees for Exceeding the Limit
While overdrafts offer convenience, businesses should be aware of the potential penalties and fees associated with exceeding the agreed-upon limit. Banks may charge higher fees or increase the interest rate if the overdraft limit is exceeded, which can add up quickly. It’s essential to monitor your overdraft usage to avoid unnecessary charges.
Zero Repayment Charges
Unlike traditional loans that often have prepayment penalties, businesses can repay their overdraft amount in a lump sum without relying on EMIs.This flexibility allows businesses with fluctuating cash flow to repay as soon as they have the funds available, reducing the overall cost of borrowing.
Minimum Monthly Payment
Many overdraft facilities require a minimum monthly payment, which is a fixed amount businesses must pay each month, regardless of the overdraft balance. This ensures that the business is making regular repayments, helping to keep debt levels manageable. The minimum monthly payment typically includes both principal and interest, allowing businesses to gradually reduce the overdrawn amount while keeping their financial obligations in check.
Joint Borrowers
In certain cases, businesses can have joint borrowers on an overdraft facility. This means that multiple individuals, such as business partners or co-owners, can be responsible for repaying the overdraft. Having joint borrowers can be especially beneficial for small or family-run businesses, as it spreads the financial responsibility across multiple people. This can also improve the business’s chances of being approved for a higher overdraft limit, depending on the financial situation of the joint borrowers.
Benefits of Overdraft for Businesses
Instant Access to Funds
One of the main advantages of an overdraft facility is that it provides immediate access to funds when cash flow is low. This ensures that businesses can continue their operations without disruption, even if their account balance temporarily falls short. It’s especially useful in emergencies or when there are unforeseen expenses.
Flexible Repayment Terms
Unlike traditional loans that require fixed repayments, overdrafts offer businesses the flexibility to repay the borrowed amount whenever they have the funds available. This makes it easier for businesses to manage their finances, as they aren’t tied to a rigid repayment schedule and can choose to pay off the overdraft as soon as they have extra cash flow.
Zero Repayment Charges
Many overdraft facilities come with zero repayment charges, meaning businesses aren’t penalized for repaying the overdraft balance early. This provides significant flexibility, allowing businesses to pay back the amount in a lump sum rather than relying on fixed monthly installments (EMIs). As a result, businesses can avoid additional fees while clearing their debt faster if funds are available.
No Collateral Required
Most overdraft facilities do not require businesses to pledge collateral, unlike traditional loans that demand assets as security. This makes overdrafts an attractive option for smaller businesses or startups that may not have valuable assets to offer but still need access to short-term funding.
Easy to Manage
Overdrafts are typically linked directly to a business’s current account, which makes them easier to manage. Businesses can monitor their spending, track their overdraft usage, and receive real-time updates, all from within their existing banking platform. This simplicity in management allows businesses to stay on top of their finances without extra administrative effort.
Short-Term Funding Solution
Overdrafts are ideal for covering short-term cash flow needs, such as paying for unexpected expenses, covering payroll, or paying suppliers. They offer quick access to funds without the need for lengthy application processes or approval delays. This makes overdrafts a great solution for businesses that need immediate funding but do not require long-term loans.
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Precautions Around Using Overdraft
Interest on Overdrawn Amount
While overdrafts can be very useful, they typically charge interest only on the amount that is overdrawn. This means that if a business leaves the overdraft balance unpaid, the interest can accumulate quickly, adding up to significant costs over time. It’s important for businesses to manage their overdraft usage carefully to avoid excessive interest charges.
Higher Interest Rates
Overdraft facilities often come with higher interest rates compared to other forms of financing, such as business loans. The higher rates can make overdrafts an expensive option if used frequently or for extended periods. Businesses should consider other financing options if they need to borrow larger amounts or if they plan to carry a balance over a long period.
Risk of Exceeding the Limit
Businesses need to be careful not to exceed their overdraft limit. If they do, they may incur additional charges or higher interest rates. Exceeding the limit can also lead to penalties and a potential reduction in the overdraft limit, which can further affect the business’s financial stability.
Can Encourage Over-reliance
While overdrafts are a convenient financial tool, businesses may become overly reliant on them if they don’t manage their cash flow properly. Regularly using the overdraft for daily expenses can lead to financial strain, as businesses may find themselves continually borrowing and struggling to repay the amount in full.
Impact on Credit Score
If an overdraft is not repaid on time or the business frequently exceeds the limit, it can negatively impact the business’s credit score. Over time, this can make it harder to access other forms of credit, such as loans or lines of credit, and may lead to higher borrowing costs.
Penalty for Exceeding Limit
Exceeding the overdraft limit is not just a matter of paying more interest; businesses may also face penalty fees. Banks may charge additional fees for every day the limit is exceeded or apply higher interest rates on the excess amount. This can make overdrafts more expensive if not carefully monitored.
FAQs
Can I get an overdraft on my current account?
Getting an overdraft on your current account depends on your bank and its specific offerings. Some banks automatically provide overdrafts with limitations, while others may require an application process. It's best to contact your bank directly to inquire about their overdraft policies and eligibility criteria.
Is overdraft a current or non-current liability?
A overdraft is a current liability since it is due within one year as a short-term loan.
Am I eligible for an overdraft?
Different banks have different eligiblity criteria for overdraft facilities. Having steady cash flow and maintaining the minimum balance required, as well as maintaining a good relationship with the bank is always beneficial. It also helps to demonstrate strong creditworthiness and responsible financial management.
Is overdraft facility only given to current account holders?
Overdraft facilities are primarily offered to current account holders. These accounts are designed for daily transactions and allow overdrafts to help manage short-term cash flow needs. However, some banks might offer similar facilities linked to savings accounts, with stricter limitations and potentially different terms compared to current account overdrafts.
