Borrowing money is a part of life for both businesses and people. When we run into problems with money, we all look for ways to borrow money to help us get through them. When you need money quickly and the interest rates on loans are going up, it may not seem like a good idea to get a loan from a bank. This is where an overdraft or overdraft account facility from your bank comes in handy.
An overdraft facility is ideal for people who regularly experience gaps in their cash flow but have the ability to pay back the amount they borrow in a relatively short amount of time. This comprehensive guide will cover various aspects of bank overdraft or OD.
What is an Overdraft?
Overdraft is a financial tool that lets you take money out of your bank account (savings or current) even if it has no money in it. Most banks and NBFCs (Non-Banking Financial Corporations) let account holders go over their limit.
You can also think of the overdraft facility as a way for banks to give you more credit. When you apply for an overdraft account at a bank, you will be given an overdraft limit based on how well you know the bank. You can take out money up to the limit and pay it back within a certain amount of time. The basic meaning of “bank overdraft” is that the bank will let you borrow a certain amount when your account doesn’t have enough money to cover the withdrawal.
According to the lender’s terms and conditions, you may also have to pay interest on the amount you’ve used from your total overdraft limit at a certain rate. The interest rate on an overdraft varies from lender to lender and depends on how much money is in your bank account and how well you know the bank.
What is an Overdraft Account?
When a person’s bank account balance goes below zero, creating a negative balance, this is called an overdraft. It usually happens when there are no more funds in the account, but an outstanding transaction is processed through the account, leaving the account holder with a debt.
Overdraft Account is the full name for an OD Account. It’s a type of account where a bank lets you make a transaction or take money out even if you don’t have any money in the account. You can borrow a certain amount of money from the bank.
With an overdraft account, the bank automatically lends the account holder the amount needed to complete the transaction. This amount, plus any possible fees, is a debt that needs to be paid back. Even though it seems helpful to the account holder, costs can get out of hand if overdrafts aren’t taken care of quickly and correctly.
Example of Overdraft Account
Think about the following situation. Let’s say Mary went to a store and bought Rs.2,000 worth of cosmetics, which she paid for with a cheque. But when the store owner put the cheque in the bank, Mary’s account only had Rs.1,500 in it. This means that she owes Rs.500.
There are two possible outcomes: either the merchant’s bank will pay him the full amount, or they will send the cheque back to Mary’s bank marked “NSF” (non-sufficient funds). If the first thing happens, Mary will have to pay the Rs.500 overdraft fee.
Interest on an Overdraft Bank Account
The interest rate that the bank charges on an overdraft is only based on the amount that was taken out of the total amount that was approved. So, it will be different for each lender and will depend on how much you need to go overdrawn, how much money is in your current or savings account, and your existing relationship with the respective Bank.
Features of an Overdraft Facility
- Applicants for an OD account are given a limit on how much they can go overdrawn. For each applicant, this limit can be different.
- On the amount used from the approved overdraft limit, interest will be charged. It’s calculated every day and charged to the account at the end of every month. If you don’t pay the interest on time according to the schedule, it will be added to the principal amount. The interest will then be charged or figured out based on the new principal.
- When you pay back the money you borrowed through an overdraft, you don’t have to pay any fees.
- There is no minimum amount you have to pay back each month if you have an overdraft facility, as long as the amount you owe is within the limit that was approved. If you don’t pay back an overdraft right away, it can hurt your credit score.
- Most banks also offer a way to go overdrawn together. With this, you and another person can take out an overdraft together, and you will both be responsible for paying back the money you borrow. It also means that if one of you can’t pay the amount used from the overdraft limit that was approved, the other has to pay the whole amount. No matter how much overdraft each borrower has, if they don’t pay back their loans, their collateral will be at risk.
- The lender decides overdraft repayment tenure, and it has full control over the OD account and how it is used.
Types of Overdraft Facility
There are secured and unsecured overdraft options, similar to loans. In other words, you will need to offer collateral if you choose a secured overdraft account. There are several different types of collateral you might offer. These are:
1. Overdraft against the salary
This option is available to salary accounts opened by firms for their employees. In order to use the overdraft facility in a salary account, you must meet the bank’s approval criteria and have a regular monthly pay credited by your employer.
- Banks provide Up to three times the customer’s current wage can be borrowed.
- The service is provided with less paperwork and an easy-repay function.
- Customers have the option to refund the money at any time without incurring pre-closure fees, and they are only required to pay interest on the amount that has been used
- According to particular banks, the minimum salary cap ranges from Rs. 15,000 to Rs. 25,000.
- There are no collateral or security requirements for this kind of overdraft.
- Some financial institutions even provide overdrafts up to Rs. 4 lakh.
2. Overdraft against the equity
Equity can be utilised to obtain an overdraft facility even if it is not advised to use it as a form of collateral. This is due to the fact that the value of stocks fluctuates due to market conditions. As a result, there are fewer overdrafts that are allowed using equity as collateral. The value of equity investments is the foundation for this. Additionally, since equity is market-linked and its value fluctuates over time, certain banks would not accept it as a form of collateral.
3. Overdraft against Fixed Deposits (FDs)
If you don’t require a high limit, fixed deposits operate as a superior collateral choice to real estate. There is less paperwork and the process is speedier. Another benefit of this option is that the application procedure for an overdraft account will be hastened if you already have a fixed deposit with the bank. Additionally, the interest rate is lower, and the sanctioned maximum can go up to 75% of your fixed deposit.
4. Overdraft against an insurance policy
The amount you can borrow depends on the surrender value of your insurance policy if you use it as collateral for an overdraft. Since an insurance policy has a larger loan to value than a fixed deposit does, the bank will authorise you for more money if you keep your insurance policy as collateral rather than holding a fixed deposit for the same amount.
5. Overdraft against property
Your residence serves as the security for an overdraft facility. Customers with a home loan who need money to settle an outstanding debt may also qualify for an overdraft. Before the house is accepted as collateral, the property is inspected, valued, and assessed. Overdraft funds are not released right away since they are issued using the property as security. The allowed overdraft amount typically ranges from 40% to 50% of the value of the property. Your credit history and ability to repay are also considered when securing an overdraft using your house as collateral.
Differences between an Overdraft and Term Loan
Overdraft is a credit line facility.
The term loan is a type of borrowed capital or funds.
Interest is computed every day.
In term loan Interest is computed every month.
Interest is assessed on the portion of the sanctioned limit that has been used.
Over and above the overall loan amount, interest is charged.
An overdraft can be availed when the account balance is zero.
Term loans may be obtained if you meet the bank’s eligibility requirements.
It is used for a temporary purpose.
It is borrowed for a long period of time in general.
The rate of interest is fixed (for at least a year).
Both fixed and variable interest rates are possible.
EMIs are used to pay it back.
It may be paid back with cash or by making bank deposits.
Overdraft accounts have the potential to be a boon, but they also have the potential to become a curse if their management is not handled correctly. An immediately accessible line of credit is always appealing, but in order to keep yourself away from getting into any critical situations in the future, you should spend the money on that line of credit wisely.
1. Is it better to get an Overdraft Account than a personal loan?
Ans: Both of these banking products can help with money problems. Any bank can give you a personal loan, but only the bank where you have a savings or current account can give you an overdraft facility.
2. What would happen if I do not pay the amount debited from my Overdraft Account?
Ans: If the overdraft amount isn’t paid back on time, the bank will have to take the amount owed plus interest from the linked savings or current account.
3. Does applying for an overdraft impact one’s credit score?
Ans: When you apply for an OD account, it doesn’t make a big difference in your credit score. But if you don’t make your payments on time, it can affect you.
4. What’s the difference between an overdraft and a term loan?
Ans: The main difference between an overdraft and a bank loan is that you only pay interest on the amount you use with an overdraft, but you have to pay interest on the whole loan amount with a term loan.
5. Is a bank overdraft a short-term or long-term obligation?
Ans: Since the time it takes to pay back an overdraft is 12 months, it is a current liability. You can also think of an overdraft as a short-term loan.
6. How can I get money once my overdraft is approved?
Ans: Once the overdraft limit is put on your current account, you can get your money the same way you normally do. You can use an ATM, a chequebook, or even internet banking to get them.
7. When do I have to pay back the overdraft?
Ans: Since the overdraft limit is meant to help with short-term cash flow problems, it should be paid back every month. But after that, the overdraft limit can be used again. Unless something else is said, the overdraft facility is reviewed for renewal every year. If your limit won’t be extended, you’ll know one month before it runs out. You will have to make sure that any money you owe the bank has been paid back.