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

The answer to what an overdraft is: it is a type of credit facility that allows one to withdraw more money from their bank account compared to the total balance in their account up to a particular amount, as allowed by the bank. Overdrafts may be secured or unsecured, depending on lender requirements, and interest rates are normally calculated on the amount utilised. The overdraft facility can be either secured or unsecured based on the earning capacity of the client. The knowledge of how the overdraft facility works will enable one to use the facility in case of a shortage of cash.

Key Takeaways

• The overdraft enables an individual to spend more than the available balance in his/her bank account.
• The bank considers eligibility and repayment ability in granting an overdraft limit.
• An overdraft can be either secured or unsecured according to needs.
• Interest is charged only on the total overdraft amount used.
• Proper usage of an overdraft enables efficient management of cash flow problems.

How does an overdraft function and work?

An overdraft is basically an overdraft facility which enables an individual to withdraw or spend money above the amount of funds present in the bank account up to a limit approved by the bank. It may prove useful in dealing with expenses when there is not enough money present in the account.

The functioning is fairly straightforward. For example, if your bank account holds ₹5,000 but you want to make a payment of ₹8,000, your bank can approve the payment of ₹8,000 if your overdraft facility limit is ₹10,000. This implies that you borrow ₹3,000 from your bank. The amount borrowed constitutes the overdraft amount for which interest will be levied till it is paid back.

What are the Different Types of Overdraft Facilities?

Different types of overdraft facilities can be categorised by the type of bank account, income or asset. They include:

• Bank Overdraft Facility: Linked to either savings or current accounts and enables account holders to withdraw money above their account balance with the help of approved limits.
• Salary Overdraft Facility: Provided to salaried employees in case of salary accounts and based on income or repayment capacity.
• Secured Overdraft: Based on some assets like fixed deposits, insurance policies or any other securities. As there is an asset, it can be granted a larger limit or relatively lower interest rates.
• Unsecured Overdraft: No asset is required for it, and it depends on factors like income or repayment capacity.

The type of overdraft facility will determine the limits, interest rates, terms of repayment and eligibility criteria.

What Are the Benefits and Risks of Using an Overdraft?

A current account will allow you to have immediate access to money when you are short on money temporarily. Nevertheless, one should be aware of the advantages and disadvantages of such an arrangement.

Advantages of an Overdraft:

• Availability of funds instantly: It offers instant access to extra funds if needed.
• Interest is earned only on the amount utilised: Typically, interest will be charged only on the amount withdrawn and not the entire amount sanctioned.
• Borrowing and repaying as per convenience: One can utilise this facility as per need and repay the amount borrowed as per terms.
• Helpful in managing cash flow gaps: Useful in managing temporary costs.

Overdraft Risks:

• Costly borrowing: Interest plus any fees will add to the total cost.
• Risk of becoming dependent: Borrowing too often could make you dependent.
• Fees for exceeding limits: Going above the limit can earn you some extra fees.
• Trouble repaying the overdraft: Failure to repay the overdraft may impact your financial standing.