What is Overdraft?
Overdraft can be defined as a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero and its authorized limit differs from customers to customers and the same is determined on the basis of their relationship with the banking institution.
Overdraft facility is offered by banks to their account holders. In such a facility, the account holders can withdraw money from their bank account (savings or current) even when their account balance is nil. This facility is chargeable by banks and the amount charged is calculated on the basis of money that is withdrawn as an overdraft.
How Does it Work?
An overdraft enables account holders to borrow money from their current account. The bank’s levy charges on this facility and the amount charged on the same depends on the money withdrawn as an overdraft. An account holder can request their bank for providing him or her with the facility. In some cases, an account holder might automatically receive such a facility from his or her bank.
Example
Mike purchased raw materials from Billy and handed him a check of $5,000 towards the payment for the transaction. Billy deposited the check in the bank. Mike had insufficient funds in his bank. Mike had a $4,000 account balance and was a shortage of $1,000. In this case, there are two probable outcomes. Mike’s bank can pay billy the amount in full, or can bounce the check on account of insufficient funds. If in case, the first probable outcome takes place, Mike will be levied with overdraft charges at $1,000.
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Types of Overdraft
#1 – Authorized Bank
The arranged bank is a type of facility that is arranged before-hand between the bank and its account holders. The account holders will agree upon a borrowing limit with their bank and can, therefore, spend money up to that prescribed limit via all the regular payment options available to them. This arrangement is chargeable and the service fee levied varies from banks to banks and generally the fee is charged on a daily, weekly or monthly basis along with the interest rate that ranges between 15 to 20 % as a yearly percentage rate.
#2 – Un-Authorized Bank
An unarranged bank is a type of facility that is not arranged before-hand and it takes place when an account holder has already spent more than his or her account’s balance. Such type of overdraft turns out to be more expensive as the same is levied with higher charges as compared to the authorized facility.
Reasons
An account holder can borrow money only for business purposes. He or she can borrow money for personal purposes too but it is highly not recommended at all as it tends to breach the terms of the facility and business loan. But this does not mean that the borrower will be required to present a receipt of each and every transaction made via his or her checkbook. In case the account holder exceeds the permissible overdraft limit then the bank might choose to delve deeper into his or her every single transaction.
Importance
An overdraft facility is a perfect credit option for account holders that are in urgent need of short-term loan amount. This facility prevents an account holder from getting his check bounced on account of insufficient bank balance. This further prevents the credit ratings of an account holder from getting impacted due to his bouncing of check at the bank. This facility helps the account holders in clearing off their payments on time and maintaining a positive relationship with their business parties. Another significant aspect of this facility could be the fact that the account holder will only need to pay interest on the amount that is borrowed as an overdraft.
Advantages of Overdraft
- Prevents Bouncing of Checks: With this facility, an account holder can prevent his or her checks from getting bounced and can maintain his or her credit ratings.
- Timely Payments: This facility assists the account holders in timely clearing their pending payments and avoids the occurrence of late payments even if their account balance is zero.
- Minimal Paper-Work: This facility requires minimal paperwork as compared to other loan options available.
- Flexibility: This facility can be availed at any time and for any amount (that is equal to or below the permissible limits).
- Ease of Application: It can be availed by an account holder at any point in time.
- Minimal Interest: This facility requires users to pay interest only upon the funds that are withdrawn by the account holders.
- Convenience: This facility provides users a lot of conveniences since it can be done any time until and unless the agreement is not terminated by the bank.
Disadvantages of Overdraft
- This facility charges a higher interest rate as compared to other loan options.
- An account holder might have to pay penalty fees if he or she crosses the permissible limit.
- If an account holder fails to pay back the amount, then he and his assets will be personally liable for the clearance of the dues.
Conclusion
This facility is an option provided by the banks to its account holders where the latter is allowed to withdraw money up to the permissible amount in case their account balance is low or zero. The two types of overdrafts are authorized and unauthorized. The unauthorized facility is more expensive as compared to the authorized bank overdraft facility since the former is not arranged in advance while the latter is arranged in advance. It must be noted that this facility is more like debt and the account holder, in this case, is the borrower while the bank is regarded as the lender. There are multiple loan options available in the market, and a borrower must evaluate other options and then opt for the cheapest of all options.
Recommended Articles
This has been a guide to what is an overdraft and its meaning. Here we discuss types (Authorized Bank and Unauthorized Bank) and how does overdraft work along with an example, advantages and disadvantages. You can learn more from the following articles –
