Overdraft

An Overdraft is a financial facility offered by banks that allows an account holder to withdraw money or make payments even when their account balance is zero or below zero, up to an approved credit limit.

The bank essentially extends a short-term loan to the account holder, which they can repay at their convenience with interest charged only on the amount used. What is an Overdraft? There are two main types: secured and unsecured overdraft. A secured overdraft is backed by collateral such as a fixed deposit, property, or shares. For example, if you have a fixed deposit of ₹10 lakhs with a bank, they may offer you an overdraft facility of up to 90% of the FD value at a lower interest rate than a personal loan. An unsecured overdraft, also called a Cash Credit facility, does not require collateral but may have higher interest rates and stricter eligibility criteria. Overdraft facilities are most commonly used by businesses to manage short-term cash flow gaps. A shop owner who needs to pay wages on the 1st of the month but is waiting for a large payment from a customer on the 5th can use an overdraft to bridge this gap. The interest is calculated only on the amount actually used and for the number of days it is used. Interest rates on overdrafts are typically higher than on term loans. They range from 10% to 18% per annum depending on whether the overdraft is secured, the borrower's credit profile, and the bank. The interest is charged monthly and must be paid regularly, typically along with a portion of the principal used. Banks offer overdraft facilities based on the account holder's banking history, credit score, income, and relationship with the bank. Existing Current Account holders with a good track record may be pre-approved for an overdraft limit. For new customers, the bank may require a detailed review of financial documents before sanctioning an overdraft. From a financial planning perspective, an overdraft is best used as a short-term liquidity tool, not as a long-term borrowing solution. Using an overdraft for extended periods can lead to a debt trap due to the compounding effect of high interest rates. Always aim to repay the overdraft amount as quickly as possible to minimize interest costs.