What is an Overdraft Facility and How Does it Work?

Running a business often involves unexpected expenses or urgent payments, and sometimes the funds available in your account may not be enough to cover these costs. This situation can lead to problems like bounced cheques and additional charges. To avoid such issues, many businesses use a banking option known as an Overdraft Facility.

An overdraft facility allows you to spend more money than you have in your account, up to a certain limit. It’s a helpful tool to manage cash flow and handle financial shortfalls.

What is an Overdraft?

An overdraft is a service provided by banks where you can continue to withdraw money from your account even when the balance reaches zero. The bank lends you the extra money, which you must repay with interest or a fee. This borrowed amount is usually required to be paid back within a specific period.

What are the Different Types of Overdraft Facilities? 

Here are the different types of overdraft facilities that you can avail to deal with liquidity issues: 

Overdraft Against Property 

The bank may offer an overdraft facility and release funds, keeping your house as collateral. This credit facility is also offered to individuals looking to repay their home loan payments. However, before approving the house as collateral, the bank may assess your property to evaluate its current value. 

Overdraft Against Fixed Deposit

Getting an overdraft facility against your FD is easier than availing this facility against your property, as it takes time to evaluate the true value of your home or shop. Also, an overdraft facility against the FD is beneficial for the bank as they already have an FD account and know their status.

Overdraft Against Insurance Policy

You can also avail the overdraft facility by keeping your insurance policy as collateral. Its credit limit will be decided based on the surrender amount of your policy. 

Overdraft Against Salary 

Banks often offer overdraft facilities against salaries for salaried individuals. The sanctioned amount can be up to 2-3 times the take-home salary, but it can vary from bank to bank. However, you must have a salary account with the lender, which makes things easy and speeds up the process. 

Overdraft Against Equity Shares or Mutual Funds

You can avail overdraft facilities against your mutual funds or equity shares, but it is highly likely that you will get a low sanctioned amount. It is because the value of your equity shares is dependent on the market, which faces major fluctuations and volatility.

Key Features of Overdraft Facility

Approved OD Limit

When you avail for the overdraft facility, the bank will decide the final approved credit limit. This limit varies from lender to lender but is decided based on various factors such as income, credit score, bank relationship, debts, collateral type, business turnover, inventory, and receivables. 

Interest Rate

Banks charge the interest rate on the amount used from the total limit. The rate is decided on a daily basis, which is billed to you at the end of the month. If you default on the payments as per the set schedule, then the interest charged will be added to the principal amount, and then the interest rate will be calculated on the new principal amount.

Nil Prepayment Charges

In other credit facilities, you will have to pay interest as well when you make prepayments. However, when you avail overdraft facilities, you can make repayments if you do not need to pay the prepayment charges. In addition to this, you can make cumulative payments and don’t need to make an agreement for paying in installments.

No Installment Payments 

An individual who avails the overdraft facility from the brand can repay the amounts cumulatively when the person has a surplus amount. You don’t have to pay the amount in installments. You can pay any amount you want at any time just before the schedule ends. 

Joint Credit Account

An overdraft facility allows joint credit accounts, meaning you and your friends both can apply for this credit facility and are responsible for paying back the loan amount. Also, no matter how much is distributed, if anyone defaults, the responsibility for the timely payments falls on you.

How Does an Overdraft Facility Work?

When your account balance drops to zero, the overdraft facility kicks in, allowing you to continue making payments or withdrawals. As you use the overdraft, you’ll be charged interest or a fee based on how much you’ve borrowed and how long it remains unpaid.

Here’s a simple example:

Imagine you have Rs 3000 in your account but need to pay Rs 5000. Without an overdraft, your cheque might bounce, leading to additional charges. However, if your bank has granted you an overdraft of Rs 2000, the payment will go through. The bank will consider the extra Rs 2000 as a loan, and you’ll need to repay it along with interest.

How is Interest Calculated on an Overdraft?

Interest on an overdraft is calculated daily based on the outstanding amount. If you borrow Rs 2000 today and repay Rs 1000 tomorrow, the interest will be charged on Rs 2000 for one day and on Rs 1000 for the next day. This daily calculation continues until the entire amount is repaid.

What are the Major Benefits of an Overdraft Facility?

Here are the key benefits of using an overdraft facility: 

Instant Funds: The facility allows you to withdraw more than your available balance to have instant emergency funds to meet liquidity issues. 

Interest on Used Amount: The bank only charges interest on the used amount out of the total sanctioned limit. 

Cumulative Repayments: Pay whenever you have a surplus amount, anytime you want.

No Collateral Withdraw: If the bank approves an unsecured overdraft facility for you, then no collateral is required to borrow. 

Digital Process: Banks now allow consumers to apply for overdraft facilities 100% digitally. 

Improves Credit Score: You can improve your credit score with timely payments and make it easy to get unsecured credit next time.

Disadvantages of an Overdraft Facility

• Higher Interest Rates: Overdrafts usually come with higher interest rates compared to other types of loans, which can make them expensive if used for long periods.
• Limited Borrowing: The amount you can borrow is usually limited and may not be sufficient for large expenses.
• Bank Dependency: The bank can change your credit limit or demand repayment sooner than expected, which can be inconvenient.

Who Should Apply for an Overdraft Facility?

Here are the ideal candidates who should apply for the overdraft facility:

Salaried Individuals

Salaried individuals with variable pay can apply for an overdraft facility. They may face cash problems before payday or receive bonuses based on performance, and can leverage this credit facility to avoid penalties and high credit card interest.

Business Owners

An overdraft facility is also ideal for business owners to cover working capital needs for daily operations. They can leverage this facility to deal with client payments and inventory purchases with a short-term credit facility without disrupting core cash flows. 

Freelancers and Self-Employed Individuals

Individuals who freelance or run startups can also avail this credit facility to deal with liquidity issues during slow business months. This facility allows them to deal with cash flow needs while avoiding heavy interest amounts on other credit facilities.

Eligibility Criteria for an Overdraft Facility

Eligibility for an overdraft depends on several factors:

• Financial Health: The bank will check your financial statements, tax records, and bank account activity to determine if you can repay the overdraft.
• Business Age: If you’re applying on behalf of a business, the bank may require the business to be operational for at least two years.
• Collateral: Some overdrafts are secured by collateral like property or fixed deposits. The bank will assess the value of this collateral before granting the facility.
• Credit Score: A good credit score is important. Banks typically look for a CIBIL score of 750 or higher.

Documents Required for an Overdraft Application

To apply for an overdraft, you’ll need to provide several documents, including:

• KYC Documents: Identification proof such as PAN Card, Aadhaar Card, or Voter ID.
• Income Proof: Income tax returns, balance sheets, and profit & loss statements.
• Business Documents: GST registration, company profile, bank statements, etc.
• Loan Documents: If you’ve taken loans before, the bank may ask for details like sanction letters and repayment records.

How to Apply for an Overdraft Facility

Applying for an overdraft facility is straightforward. You can visit your bank or apply online. The bank will review your application and may ask for financial documents like bank statements, income proofs, and business records. If your application is approved, the overdraft facility will be added to your account, and you’ll be notified.

For businesses, it’s also possible to get a pre-approved overdraft, where the facility is automatically activated when your balance reaches zero.

How to Repay an Overdraft

Repaying an overdraft is flexible. You can pay back the amount in full or in parts, as long as you stay within the bank’s guidelines. The more you repay, the less interest you’ll be charged. Once you’ve repaid the full amount, you can use the overdraft facility again if needed.

Is an Overdraft the Same as a Loan?

Yes, an overdraft is similar to a loan because you are borrowing money from the bank. However, there is a key difference: with an overdraft, you only pay interest on the amount you’ve borrowed, not on the entire overdraft limit. This means you’re only charged for what you actually use.

Also Read: Types Of Trade Finance Products: Financing Foreign Trade

Difference Between Overdraft and Cash Credit

While both overdrafts and cash credit are used to manage working capital, they differ in certain aspects:

• Collateral: Cash credit is often secured against inventory or stock, whereas overdrafts are usually secured against property or other assets.
• Borrowing Limit: Cash credit limits can be adjusted based on business performance, while overdraft limits are fixed.

Also Read: Different Types of Working Capital Loan Explained

FAQs

Is overdraft secured or unsecured?

An overdraft can be either secured (backed by collateral) or unsecured (based on creditworthiness alone).

How does overdraft appear on the balance sheet?

Overdrafts are listed as a current liability on the balance sheet since they represent a short-term borrowing.

Are there any additional fees for overdrafts?

Yes, banks may charge a processing fee and daily interest based on the amount borrowed.

Does an Overdraft affect your credit score?

Using an overdraft responsibly won’t negatively impact your credit score, but exceeding your limit or failing to repay on time can.

Can an overdraft be repaid in installments?

Yes, you can repay the overdraft in installments or in full, depending on your preference.