What is Bank Overdraft & Types of Bank Overdraft in 2024

Bank overdrafts help individuals withdraw funds even with no money or insufficient funds in their account. It is a short-term loan facility that allows meet cash emergencies. In this guide, you will explore how you can avail a bank overdraft, its types, advantages, and a lot more.

What is a Bank Overdraft?

An overdraft occurs when a transaction or withdrawal exceeds the available funds in an individual’s bank account. In such a case, the bank allows the transaction even in the lack of funds. It can be thought of as a credit facility extended by banks and financial institutions that is given to the account holder when their account runs short of funds. It allows the individual to withdraw money even when the account holder has insufficient funds for the withdrawal he/she is trying to make or no funds at all.

But this doesn’t mean that this excess amount given by the banks comes for free. There is an interest fee for the amount given, and it is charged for each bank overdraft given to the individual. Also, there is a certain limitation to the amount that can be withdrawn that varies from one bank to another.

Working of Bank Overdraft

An overdraft grants you the opportunity to borrow funds by withdrawing more funds than the actual available funds in your account. However, such borrowing costs the individual an additional fee for the same but helps in getting immediate funding in time of need. It can be thought of as a short-term loan that you can ask for from the overdraft bank, but the sanctioning power is the sole discretion of the bank which is decided after taking a look into your credit history and financial standing. Also, different types of overdrafts are made available to customers; here are a few of them:

Types of Bank Overdraft

1. Authorized Bank Overdraft

The authorized overdraft is based on a prior agreement between the account holder and their respective bank. In such a case, a mutually agreed-upon borrowing limit is established for use across all typical payment methods. A service fee is charged for such an arrangement, which may vary from one bank to another. The fee is commonly assessed on a daily, weekly, or monthly basis, with an annual percentage rate that usually ranges between 15% and 20%.

2. Unauthorized Bank Overdraft

Opposed to authorized bank overdrafts, unauthorized overdrafts are not pre-authorized and result when the account holder has spent beyond the available balance. Even with a pre-existing agreement, unauthorized overdrafts can occur when the account holder surpasses the agreed-upon overdraft threshold. Higher fees are applied to unauthorized overdrafts, making them a more expensive option.

3. Overdraft Against Property

An overdraft facility, as the name suggests, is an overdraft that is obtained against one’s house as collateral. Overdraft options are also available for homeowners seeking additional funds to meet their existing home loan obligations. But, before the house is taken as collateral, the evaluation of the property is done beforehand. Overdraft funds secured with property collateral are subject to a delay in disbursement because the property assessment is done prior to the disbursement of funds. Usually, the amount that is sanctioned ranges between 40 to 50% of the total worth of the property. Besides, credit history, repayment capacity, and financial stature also play a vital role in approving overdrafts against a house as collateral.

4. Overdraft Against Fixed Deposits

As you can make out by the name, such overdrafts on FD are given against fixed deposits as collateral. This mode of obtaining an overdraft is comparatively easier than getting an OD approved by placing house as a collateral. It is because the evaluation of property takes time, whereas it becomes a lot easier for the lender to approve an overdraft against a fixed deposit because the FD account exists within the lender bank and offers an easy way out to disburse overdraft funds.

Also, another advantage of such an overdraft against FD is that you can attain an overdraft sanctioned that amounts to about 75% of the fixed deposit amount. The interest levied on such overdrafts is also comparatively less than overdraft against a house as collateral.

5. Overdraft Against Insurance Policy

Such overdrafts are sanctioned against the insurance policy one holds. The surrender value of your insurance policy determines the approved sum. The loan-to-value of the insurance policy is comparatively greater than overdraft against fixed deposits and a house as collateral.

6. Overdraft Against Equity

Equity is not favored as collateral because its value is dependent on the market and is prone to fluctuate. However, you can obtain an overdraft against equity, but the amount sanctioned against it is comparatively less than other kinds of overdraft.

7. Overdraft Against Salary

Overdrafts are also offered to salaried people against their salary, which is usually two to three times the sum of your salary. However, this algorithm may vary from one lending institution to another and is a short-term loan facility offered to salaried people. To stand eligible to apply for this overdraft, one should hold their salary account in the respective bank.

Features & Characteristics of Bank Overdraft 

Here, we list down the primary features and characteristics of a bank overdraft:

• Banks provide overdraft privileges to their overdraft savings account holders with a certain predefined limit that varies from one borrower to another.
• Banks do not impose any sort of prepayment penalty on individuals who wish to repay their loans before the completion of their tenure. This feature makes bank overdrafts distinctive from other types of loans that exist.
• An overdraft loan may have joint borrowers, wherein both the applicants will be deemed to share equal responsibility for the repayment of the amount borrowed.
• EMI facility is not available for bank overdrafts. However, the borrowers have the flexibility to repay varying amounts each time without adhering to a fixed installment structure.
• The interest on the overdraft amount is levied on a daily basis and billed on a monthly basis to the borrower’s account. In the event of a default in payment, the interest charges are prone to escalate.
• In an overdraft account, transactions such as withdrawals or deposits can be made at any point in time within the defined limit.

Importance of Bank Overdraft in 2024

Here is why overdrafts are important:

• They give you quick access to funds
• You have full control over how much amount you are using extra
• There are no monthly costs involved
• It keeps you covered
• You are only required to pay interest for the amount you use

How to Prevent Bank Account Overdrafts?

Overdraft charges can be an additional cost to your expenses, and thus, to stay at bay from incurring additional expenses, here are a few tips that you can follow to prevent bank overdrafts:

• Always have an eye on the cash flow of your business. Gaining an in-depth understanding of the inflow and outflow of cash will help you attain success and manage the same more judiciously. 
• Also, while availing of an overdraft, make sure that you compare different banks and lending institutions and accordingly pick a bank that offers the best overdraft facility that charges a lower overdraft fee. 
• Keep track of all sorts of withdrawals and deposits in your account. May it be online transactions or ATM withdrawals, keep a check so that you have an idea about your account balance. This will give you a bigger picture of your account and the activities that take place in it and will help you make better financial decisions. 
• Always review your bank statements regularly to keep a check on any suspicious activity and hidden charges that shouldn’t have been deducted.

What is an Overdraft Fee? 

The annual maintenance charges, also known as the annual review charges that are charged over an overdraft account, are known as overdraft fees. It is usually a small percentage of the overdraft renewal limit, which generally ranges between 1 and 2%. In other cases, a fixed amount is also charged as the overdraft fee based on the discretion and terms and conditions of the bank. 

How Bank Overdraft is Beneficial For Business in Today’s Scenario?

There are various reasons why businesses can benefit from overdrafts. Right from paying salaries to their employees to settling invoices and buying raw materials, there are a plethora of things for which businesses can use the overdraft money for essential expenses. Here is how bank overdrafts are beneficial for businesses:

• Bank overdrafts act as a safety net as the interest is only paid on the amount you draw. Thus, you can have peace of mind thinking that you have a resource that can be used at a time of need, and interest will be comparatively lower because you only pay for what you use.
• It offers flexibility in its payment terms. You don’t have to pay the amount in monthly fixed installments. You need to inform the lender regarding the duration during which you wish the business overdraft to remain accessible and get it renewed further as per your needs. 
• One can also close the overdraft at any point in time without paying any closing fees.
• At times, when businesses run down into losses or encounter any sort of financial crisis, bank overdrafts can help fulfill business expenses. Bank overdrafts can financially support a diverse array of business entities to help you cope with your financial stress. 
• Bank overdrafts can be used as a security.

What is Overdraft Protection?

Overdraft protection entails an arrangement with the bank or financial institution to address overdrafts on a checking account. This service can be availed for a charge and is typically constrained by a predetermined maximum limit. Banks and financial institutions are not necessarily obligated to provide overdraft protection programs, and even if they offer them, they may exercise discretion in deciding whether to approve or decline a specific overdraft transaction. It is advisable to examine your overdraft bank account agreement and consult with your bank to get acquainted with the terms and conditions of any available overdraft protection programs.

With the facility of overdraft protection, when a customer’s checking account falls short of money and runs down into a negative balance, they can tap into a pre-established loan offered by the bank, incurring an associated fee. Overdraft protection serves as a means to avoid the inconvenience caused by a shortage of funds and the potential embarrassment of a bounced check. Moreover, it can help prevent non-sufficient fund fees, and in numerous instances, each type of fee tends to be approximately equal in amount.

What is the Limit For Bank Overdrafts? 

The limit of the overdraft is predetermined and is decided by the bank based on the account holder’s financial position, repayment ability, and creditworthiness. The interest rate, overdraft limit, and other terms and conditions depend on the relationship between the bank and the OD account holder who wishes to seek an overdraft facility. The overdraft limit may vary anywhere between INR 50,000 and INR 5 crores.

Advantages & Disadvantages of Bank Overdraft 

Bank overdrafts are very useful financial tools that can help businesses and individuals acquire immediate cash flow and provide short-term and flexible funds. However, there are advantages and disadvantages associated with this financial instrument, as mentioned below: 

1. Advantages of Bank Overdraft 

• Collateral is not required in the case of overdrafts.
• Overdraft can help cater to immediate requirements of funds.
• Facilitates the control and monitoring of available cash resources for a business or individual.
• Less paperwork is involved in obtaining a bank overdraft.
• The interest amount is only charged on the amount that is withdrawn and not the overall limit.
• If your overdraft account has an overdraft provision, you can make transactions and payments even when your balance reaches zero, which further prevents dishonor charges.
• Overdraft permits you to pay back the borrowed amount at your own convenience without forcing any sort of monthly payments.

2. Disadvantages of Bank Overdraft 

• The rate of interest charged on bank overdrafts may be on the higher side and may vary.
• This type of overdraft facility is available only for bank account holders.
• The bank overdraft limit offered to the account holder differs based on their financial stature, position, or the business they run.
• The interest rate is variable and is prone to change. 
• This type of loan facility is not suitable for people who wish to opt for long-term financing.

Final Word

A bank overdraft can be thought of as a short-term loan that enables bank customers to meet their financial obligations or make money withdrawals even when their account balances have been depleted. This proves beneficial for individuals in case of unforeseen circumstances, particularly when the bank extends overdraft protection. However, exceeding the account balance results in extra charges or interest, and thus, it is advisable to steer clear of such overdrawing whenever feasible.

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Disclaimer

This article is solely for educational purposes. Stable Money doesn't take any responsibility for the information or claims made in the blog.