^{1}Overdraft interest is the interest, a bank charges on overdraft facility. An overdraft is a facility of extended credit from a bank or a financial institution. This facility allows the current account holder to withdraw money even when the account balance reaches zero. In other words, this facility allows the account holder to use more funds than what is effectively available in their current account with the bank.

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## Overdraft Interest Rate

Overdraft interest rate is very different from the interest rate of regular loans in the following way –

- In overdraft facility, the interest rate is charged only for the number of days for which the current account is overdrawn, whereas in the loan, the interest rate is charged on the entire duration of the
- In an overdraft facility, the interest rate is charged only on the amount of cash overdrawn, as opposed to a loan where the interest is calculated on the sanctioned amount regardless of the usage.

## Overdraft Interest Calculation Method

The overdraft interest rate is calculated by the average daily balance method. In average daily balance method, the interest is calculated by considering the balance of a current account at the end of each day or each period.

## Calculation of Overdraft Interest by Average Daily Balance Method

The formula for overdraft interest rate by average daily balance method is as follows –

### Formula

Interest = A/N * R/P

Where –

A = Amount Overdrawn

N = Number of Days in a billing period

R = Annual interest rate

P = Number of periods per year

The banks may have different policies for compounding the interest rates. Interest rates can be compounded daily, weekly, fortnightly or monthly. The amount of interest will change with changes is the compounding policies.

## Learning with an Example

Example – Suppose XYZ Ltd. holds a current account with Bank of America. It has a current account balance of USD 5000.00 and an overdraft limit of USD 2000.00 at an interest rate of 18% per annum. We will calculate the interest rate when

1) no compounding

2) weekly compounding and

3) daily compounding

Following is XYZ Ltd. current account activity for 15 days from 01/01/2018 to 15/01/2018-

Date (DD/MM/YYYY) | Beginning Balance | Withdrawal | Deposit | Ending Balance |

01/01/2018 | 5000.00 | 5000.00 | ||

02/01/2018 | 5000.00 | 2000.00 | 3000.00 | |

03/01/2018 | 3000.00 | 3200.00 | -200.00 | |

04/01/2018 | -200.00 | -200.00 | ||

05/01/2018 | -200.00 | 350.00 | -550.00 | |

06/01/2018 | -550.00 | -550.00 | ||

07/01/2018 | -550.00 | 100.00 | -650.00 | |

08/01/2018 | -650.00 | 50.00 | -600.00 | |

09/01/2018 | -600.00 | 400.00 | -1000.00 | |

10/01/2018 | -1000.00 | 500.00 | -500.00 | |

11/01/2018 | -500.00 | 100.00 | 50.00 | -550.00 |

12/01/2018 | -550.00 | 1000.00 | 450.00 | |

13/01/2018 | 450.00 | 450.00 | ||

14/01/2018 | 450.00 | 550.00 | -100.00 | |

15/01/2018 | -100.00 | 300.00 | 200.00 |

### No Compounding

To calculate interest, we must first calculate the sum of daily balances. We must note that interest will be calculated only on the ending balances for days when the current account is overdrawn. This can be done in the following manner –

Date (DD/MM/YYYY) | Overdrawn Ending Balances |

03/01/2018 | -200.00 |

04/01/2018 | -200.00 |

05/01/2018 | -550.00 |

06/01/2018 | -550.00 |

07/01/2018 | -650.00 |

08/01/2018 | -600.00 |

09/01/2018 | -1000.00 |

10/01/2018 | -500.00 |

11/01/2018 | -550.00 |

14/01/2018 | -100.00 |

SUM OF DAILY BALANCES (AMOUNT OVERDRAWN) | 4900.00 |

Interest = A/N * R/P

As the interest rate calculation is fortnightly

A = Amount Overdrawn = 4900.00

N = Number of Days in a billing period = 15 days

R = Annual interest rate = 18% = 0.18

P = Number of periods per year = 365/15 = 24.5 periods

So, Interest = 4900/15 X 0.18/24.5 = USD 2.40

### Weekly Compounding

Following is the table in which the overdraft interest rate is compounded weekly. As per previous calculation, when finding the sum of balances interest will be calculated only on ending balances of the days on which current account is overdrawn –

Date (DD/MM/YYYY) | Beginning Balance | Withdrawal | Deposit | Ending Balance | Interest |

01/01/2018 | 5000.00 | 5000.00 | |||

02/01/2018 | 5000.00 | 2000.00 | 3000.00 | ||

03/01/2018 | 3000.00 | 3200.00 | -200.00 | ||

04/01/2018 | -200.00 | -200.00 | |||

05/01/2018 | -200.00 | 350.00 | -550.00 | ||

06/01/2018 | -550.00 | -550.00 | |||

07/01/2018 | -550.00 | 100.00 | -650.00 | ||

SUM OF BALANCES (A) (200+200+550+550+650) | 2150.00 | 1.06 | |||

08/01/2018 | -651.06 | 50.00 | -601.06 | ||

09/01/2018 | -601.06 | 400.00 | -1001.06 | ||

10/01/2018 | -1001.06 | 500.00 | -501.06 | ||

11/01/2018 | -501.06 | 100.00 | 50.00 | -551.06 | |

12/01/2018 | -551.06 | 1000.00 | 448.94 | ||

13/01/2018 | 448.94 | 448.94 | |||

14/01/2018 | 448.94 | 550.00 | -101.06 | ||

SUM OF BALANCES (B) 601.06+1001.06+501.06+551.06+101.06) | 2755.30 | 1.36 | |||

15/01/2018 | -102.42 | 300.00 | 197.58 |

Interest rate calculation is follows –

- Interest = A/N X R/P

A = 2150.00

N = 7

R = 0.18

P = 365/7 = 52

Interest = 2150/7 X 0.18/52 = USD 1.06

- Interest = A/N X R/P

A = 2755.30

N = 7

R = 0.18

P = 365/7 = 52

Interest = 2755.30/7 X 0.18/52 = USD 1.36

Total Interest = (A) + (B) = 1.06 + 1.36 = USD 2.42

### Daily Compounding

In daily compounding, the interest is calculated at the end of each day and this interest is added to beginning balance of the next day. Following is the calculation –

All amounts in USD

Date (DD/MM/YYYY) | Beginning Balance | Withdrawal | Deposit | Ending Balance | Interest |

01/01/2018 | 5000.00 | 5000.00 | 0 | ||

02/01/2018 | 5000.00 | 2000.00 | 3000.00 | 0 | |

03/01/2018 | 3000.00 | 3200.00 | -200.00 | 0.10 | |

04/01/2018 | -200.10 | -200.10 | 0.10 | ||

05/01/2018 | -200.20 | 350.00 | -550.20 | 0.27 | |

06/01/2018 | -550.47 | -550.47 | 0.27 | ||

07/01/2018 | -550.74 | 100.00 | -650.74 | 0.32 | |

08/01/2018 | -651.06 | 50.00 | -601.06 | 0.30 | |

09/01/2018 | -601.36 | 400.00 | -1001.36 | 0.49 | |

10/01/2018 | -1001.85 | 500.00 | -501.85 | 0.25 | |

11/01/2018 | -502.10 | 100.00 | 50.00 | -552.10 | 0.27 |

12/01/2018 | -552.37 | 1000.00 | 447.63 | 0 | |

13/01/2018 | 447.63 | 447.63 | 0 | ||

14/01/2018 | 447.63 | 550.00 | -102.37 | 0.05 | |

15/01/2018 | -102.37 | 300.00 | 197.63 | 0 | |

Total Interest at the end of 15 days | 2.42 |

The calculation of daily interest rates is as follows –

Interest on 03/01/2018 = USD 200.00 (overdrawn amount at the end of the day) X .18 (interest rate)/365 (number of periods per year) = USD 0.10

Interest on 05/01/2018 = USD 550.20 X 0.18/365 = USD 0.27

Interest on 07/01/2018 = USD 650.74 X 0.18/365 = USD 0.32

& Interest on 09/01/2018 = USD 1001.36 X 0.18/365 = USD 0.49

Thus, we can easily see the difference between daily compounding interest rates as against no compounding interest rates. The difference in interest rates seems small given the small value, but for bigger firms where transactions may be in hundreds of thousands of dollars, the difference will be huge. The farther the compounding cycle, the cheaper it is for the borrower. In other words, weekly compounding is better than daily compounding, and monthly compounding is better than weekly compounding.^{1}

*investinganswers*. August 2019. [Source]