What is an Overdraft? Meaning, Limit, Charges & How It Works

An overdraft is when you withdraw more money than your account balance. Banks allow customers to spend extra money up to a limit.

Example: Meera has ₹5,000 in her current account at the bank. She needs to pay ₹8,000 for her son's school fees. The bank allows her to withdraw ₹8,000 even though she only has ₹5,000. This means she uses ₹3,000 as overdraft money. The bank charges her 12% interest per year on this ₹3,000. She must pay back the overdraft amount plus interest charges.

Overdraft Features
 

Banks provide overdraft facilities to help customers during emergencies. Customers must repay the overdraft amount with interest charges promptly.

1. Understanding Overdraft Meaning and Purpose

An overdraft means borrowing money from your bank account beyond the available balance. Banks allow customers to spend more money than they actually have. This facility acts as a safety net during financial emergencies. People use overdraft when they need immediate cash but lack sufficient funds.

Example: Rajesh runs a small grocery shop in Mumbai. His account balance is ₹2,000, but he needs ₹7,000 for new stock. The bank allows him to withdraw ₹7,000 through an overdraft facility. His account now shows a negative ₹5,000 balance. He repays this amount when customers pay their bills.

Banks provide overdrafts to maintain customer relationships and earn interest income. This service helps businesses manage temporary cash shortages effectively. Individuals use overdraft for medical emergencies, education fees, or urgent repairs.

Overdraft Usage Scenarios:
 

Overdraft provides flexibility and convenience for managing unexpected expenses. It eliminates the need for lengthy loan applications during urgent situations.

2. Overdraft Limits and Eligibility Criteria

Banks set overdraft limits based on customers' income and creditworthiness. They analyse salary slips, bank statements, and credit scores carefully. Higher income earners typically receive larger overdraft limits. Banks also consider employment stability and repayment history.

Example: Priya works as a software engineer earning a ₹60,000 monthly salary. She has maintained her salary account with ABC Bank for three years. The bank offers her an overdraft limit of ₹1,80,000 (three times her monthly salary). She can withdraw up to this amount even with zero balance.

Different banks have varying eligibility criteria for overdraft facilities. Some banks require a minimum monthly income of ₹15,000. Others demand that salary accounts be maintained for specific periods. Self-employed individuals need income tax returns and business turnover certificates.

Overdraft Limits by Income:
 

Banks review overdraft limits annually and adjust them based on income changes. Good repayment behaviour can lead to limit increases over time.

3. Overdraft Charges and Interest Calculation

Banks charge interest on overdraft amounts from the day of usage. Interest rates typically range from 10% to 18% annually. Banks calculate interest daily and debit monthly from customer accounts. Additional charges include processing fees and renewal charges.

Example: Amit uses a ₹50,000 overdraft at a 14% annual interest rate. Daily interest rate becomes 14% ÷ 365 = 0.038%. Daily interest charge is ₹50,000 × 0.038% = ₹19. If he repays after 30 days, the total interest = ₹19 × 30 = ₹570.

Banks also charge penalty fees for exceeding overdraft limits. Processing fees range from ₹500 to ₹2,000 for overdraft setup. Annual renewal charges vary from ₹1,000 to ₹5,000 depending on the limit amount.

Overdraft Charges Structure:
 

Understanding the charge structure helps customers use overdraft facilities cost-effectively. Regular monitoring prevents unexpected charges and penalties.

4. How Overdraft Works in Practice

Overdraft works automatically when customers withdraw money beyond their account balance. Banks link an overdraft facility to current or savings accounts. When balance becomes insufficient, overdraft kicks in immediately. Customers can withdraw cash, make payments, or write cheques seamlessly.

Example: Sunita has ₹8,000 in her account with a ₹30,000 overdraft limit. She writes a cheque for ₹15,000 to pay rent. The bank deducts ₹8,000 from her balance and ₹7,000 from the overdraft. Her account shows a ₹7,000 negative balance. She deposits ₹20,000 the next day, making her balance ₹13,000 positive.

Banks provide overdraft through ATM cards, cheque books, and online banking. Customers receive SMS alerts when using the overdraft facility. Monthly statements show overdraft usage and interest charges clearly.

Overdraft Transaction Flow:
 

Overdraft provides seamless cash flow management without disrupting daily financial activities. Customers can manage business operations and personal expenses efficiently.

5. Advantages and Disadvantages of Overdraft

Overdraft offers several benefits, including immediate fund access and flexible repayment options. Customers pay interest only on used amounts, not the entire limit. No fixed EMI schedule makes it convenient for irregular income earners. Quick approval process saves time during emergencies.

Example: Ravi owns a small restaurant with seasonal business fluctuations. During slow months, he uses a ₹25,000 overdraft for staff salaries. When business improves, he repays the amount immediately. He pays interest only for 45 days of usage, costing him ₹1,250 at a 12% annual rate.

However, overdraft has disadvantages too. High interest rates make it expensive for long-term use. Easy access may lead to overspending and debt accumulation. Banks can reduce limits or withdraw the facility without notice.

Overdraft Pros and Cons:
 

Wise overdraft usage helps manage cash flow effectively while avoiding debt traps. Customers should maintain discipline and repay quickly to maximise benefits.

Conclusion

An overdraft helps people withdraw more money than their account balance during emergencies. Banks charge interest only on the amount used. This facility provides quick access to funds without lengthy procedures. 

However, customers must use overdrafts carefully due to high interest rates. Timely repayment prevents debt problems and maintains good banking relationships for future needs.

FAQs
 

Q1: What is an overdraft? 

An overdraft lets you withdraw more money than your account balance up to a limit.

Q2: How much interest do banks charge on overdraft? 

Banks typically charge 10% to 18% annual interest on overdraft amounts used.

Q3: Can anyone get an overdraft facility? 

No, banks approve overdraft based on your income, credit history, and account behaviour.

Q4: When do I pay interest on an overdraft? 

You pay interest only on the overdraft amount you use, not the entire limit.

Q5: How quickly can I get an overdraft approved? 

Banks usually approve overdrafts within 2-3 working days for eligible customers.

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LoansJagat Team

‘Simplify Finance for Everyone.’ This is the common goal of our team, as we try to explain any topic with relatable examples. From personal to business finance, managing EMIs to becoming debt-free, we do extensive research on each and every parameter, so you don’t have to. Scroll up and have a look at what 15+ years of experience in the BFSI sector looks like.