How does an Overdraft Facility Work?

Overdraft – Meaning

An overdraft or an OD is a line of credit provided by banks to individual and business houses. This facility allows the account holder to use more funds than what is effectively available in their current account with the bank. Nowadays, banks grant this facility to the customer’s savings account. Let us understand how does an overdraft facility work with an example –

How does an Overdraft Facility Work?

Suppose XYZ Ltd. has a current account with Bank of America. It deposited USD 10,000.00 in its current account on 1st January 2018. XYZ Ltd. has done some analysis and forecasts that it will need extra cash over and above USD 10,000.00 at some time during the year. So it applies to Bank of America for an overdraft facility up to USD 15,000.00, which the bank grants at a 5% rate of interest per annum.  On 15th January 2018, XYZ Ltd. is due to pay USD 13,000.00 to its creditor. As it doesn’t have extra cash available, it utilizes the bank overdraft facility and makes the payment. The bifurcation will be as follows:

  • Out of USD 13,000.00 – USD 10,000.00 is XYZ Ltd.’s own money & USD 3,000.00 is used from the overdraft facility. The interest will be charged on USD 3,000.00 only.

Going further, on 1st February 2018, XYZ Ltd. received a payment of USD 4,000.00 from its debtor, which is deposited in the company’s current account with Bank of America. The overdraft cycle is completed here. The borrower returned the USD 3,000.00 that it had withdrawn from the bank over and above the balance available in its current account.

  • So the interest rate calculation will be on USD 3,000.00 for 17 days (starting from 15th January 2018 to 1st February 2018, both days inclusive)

Thus the interest calculation will be –

Interest = USD 3000.00 (amount overdrawn) * 5/100 (rate of interest) * 17/365 (number of days overdrawn = USD 6.98

Apart from the interest rate, there may be other associated charges that XYZ Ltd. would have to pay for using the overdraft facility.

How does an Overdraft Work

Thus the main highlight of an overdraft facility that makes it different from other bank loans is that –

  • Overdraft is a credit facility, whereas a bank loan is a facility for borrowing a certain fixed amount of money. In other words, in an overdraft facility, a user can draw cash as and when he requires up to the amount he requires, whereas in bank loans, a fixed amount is given to the user regardless of his current finances.
  • Interest in overdraft facility is charged only on the amount drawn by the user. However, interest on a bank loan is charged on the amount sanctioned by the bank.
  • It is necessary to have an operational account in the bank to use an overdraft facility against the bank loan. It is not necessary to have an operating account.

What Overdraft Limit will I Get?

An individual or a business’s overdraft limit depends on an array of factors. Most banks provide overdraft facilities, but they sanction your overdraft limit by checking on factors such as your age, earnings, credit score, how long you have been associated with the bank, etc. How much overdraft limit a bank will give you is solely at the discretion of the bank, and the customer has no say in it, though they might be able to negotiate better terms.

Also Read: Overdraft Interest

Fees and Charges Associated with Overdraft Facility

There are many types of fees and charges associated with a bank overdraft. All these charges differ from bank to bank. Following is the list of charges that may be applicable on overdraft –

  • Interest is calculated as a percentage of the amount that is overdrawn for as long as it is overdrawn.
  • Some banks may charge a daily fee on the amount that is overdrawn until it is repaid to the bank. There can be different alternatives to this, such as there might be a weekly fee or a monthly fee, or all three. These fees are usually tiered, depending on the amount overdrawn.
  • The banks might also charge a fixed setup fee for starting the overdraft facility.

All the overdraft charges depend on multiple factors such as bank policy, the borrower’s credit score, collateral availability, customer loyalty, etc. It may happen that the same bank is offering a different rate of interest on overdraft to two different customers. This facility is completely tailor-made.

Types of Overdraft Facility

Mainly there are two types of overdraft facilities as follows:

Authorized or Agreed Overdraft

When an account holder has already applied for an overdraft, and the bank has granted the facility, then such an overdraft is termed as an authorized or agreed overdraft. The account holder can withdraw money up to the prescribed limit on predetermined interest and charges.

Unauthorized or Unplanned Overdraft

There might be instances when the account holder has not availed of the overdraft facility. However, he might want to withdraw more money from the current account than the existing balance. If the account holder tries to make a payment and there isn’t enough money, then two things can happen –

Also Read: Overdraft Vs. Loan

  1. The bank will reject the payment or
  2. The bank will sanction the payment and consider the payment request as a request for an unauthorized

Bank will give unarranged overdrafts as per their bank policy and account holders’ credit score. Usually, the interest rates and other charges are very high on unarranged overdrafts compared to an authorized overdraft facility.

The overdraft facility can also be classified by different criteria as follows –

  • Secured Overdraft – Overdraft facility that is covered by assets pledged to the bank
  • Unsecured Overdraft – Overdraft facility without any collateral

To run through, we must understand that an overdraft facility serves a very specific purpose for a business or an individual. An entity can decide whether it needs a bank loan or not because such projects are pre-planned. But what about contingent needs, unexpected expenses, and a cash crunch in the day-to-day operating cash cycle? These can’t be planned, and a loan can’t be taken for these. Overdraft is the only alternative to take precautionary measures for such expenses. It is like a cushion for turbulent times.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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