Overdraft : Defination | Advantages | Disadvantages
What is an ‘Overdraft’
An overdraft is an extension of credit from a lending institution when an account reaches zero. An overdraft allows the individual to continue withdrawing money even if the account has no funds in it or not enough to cover the withdrawal. Basically, overdraft means that the bank allows customers to borrow a set amount of money.
When would I need an overdraft?
We’ve all been there, when the bills are due and payday hasn’t come around yet. Overdrafts come in handy when you need to proactively manage these common cash flow situations.
Where an overdraft facility is not arranged in advance, banks charge what is known as an “account overdrawn fee” when your balance goes below zero.
For example, at Westpac this fee is $15, charged once on any given day that a customer overdraws their account and it isn’t corrected by the end of the day (excluding the Choice – Concession holders and Reward Saver – Under 12 accounts).
Benefits of a bank overdraft
An overdraft allows you to access extra funds through your transaction account up to an approved overdraft limit, avoiding overdrawn and dishonour fees.
Interest is only charged on the amount overdrawn (when fees and charges are paid on time). A monthly service fee may also be charged, depending on the type of overdraft you choose.
You can make withdrawals using your overdraft in all the usual ways, including at an ATM, in branch, Debit Mastercard, BPAY®, Online, Mobile, Telephone and EFTPOS.
Overdrafts don’t have a set repayment schedule, allowing you to decide when you want to make a repayment, for example, when your salary is credited to your account.
You should also carefully consider the overdraft limit you apply for to avoid overspending.
Credit criteria, terms and conditions, fees and charges apply.
BREAKING DOWN ‘Overdraft’
If you have an overdraft account, your bank covers checks that would otherwise bounce and get returned without payment. As with any loan, you pay interest on the outstanding balance of an overdraft loan. Often, the interest on the loan is lower than credit cards. In many cases, there are additional fees for using overdraft protection that reduce the amount available for overdraft protection, such as insufficient funds fees per check or withdrawal.
Overdraft and Your Credit Score
Your bank can opt to use its own funds to cover your overdraft. Another option is to link the overdraft to a credit card. If the bank uses its own funds to cover your overdraft, then it typically won’t affect your credit score. When a credit card is used for the overdraft protection, it’s possible that you can increase your debt to the point where it could affect your credit score. However, this won’t show up as a problem with overdrafts on your checking accounts.
If you don’t pay your overdrafts back in a predetermined amount of time, your bank can turn your account over to a collection agency. This collection action can affect your credit score and get reported to the three main credit agencies. It depends on how the account is reported to the agencies as to whether it shows up as a problem with an overdraft on a checking account.
Overdraft Protection as a Useful Tool
Overdraft protection provides you with a valuable tool to manage your checking account. If you forget to take out money for a trip to Starbucks, overdraft protection ensures that you don’t have a check returned and reflect poorly on your ability to pay. However, banks charge a fee and make money from this service; make sure you use the overdraft protection sparingly and only in an emergency situation.
The dollar amount of overdraft protection varies by account and by bank. In some cases, the customer needs to request the addition of overdraft protection. If the overdraft protection is used excessively, the financial institution can remove the protection from the account.
Advantages and Disadvantages of Bank Overdraft
ADVANTAGES OF BANK OVERDRAFT
HANDLES TIMING MISMATCH OF FLOW OF FUNDS
A bank overdraft is usually helpful for a business where it has cash flows moving in and out many times during a month. In other words, if sales proceeds and purchases result in a flow of money in and out many times during a week/month; an overdraft facility allows managing cash flow gaps that might arise due to timing mismatch.
HELPS IN KEEPING GOOD TRACK RECORD
It helps to maintain a good payment history as any payment made via cheque does not bounce due to insufficient funds, which may have been made against some receivable, which may come a couple of days later.
TIMELY PAYMENTS
It also aids in ensuring that timely payments are made and no late payments penalties are faced, as payments would be made even if there is no balance in the account.
LESS PAPERWORK
Overdraft facility is usually easy to avail compared to long term loans which may require more paperwork.
FLEXIBILITY
Overdraft facility is flexible in the nature that one may take it whenever required for whatever amount (up to the limit allotted) and for even as less as one or two days.
THE BENEFIT IN INTEREST COST
Since the interest is calculated only on a number of funds utilized, there are great savings in the interest cost when compared to a normal loan was taken on fixed interest rate. In other loans, you have to pay interest even if you are not using the money. The meter of interest starts with the payments you make but it stops instantly when there are receipts.
DISADVANTAGES OF BANK OVERDRAFT
HIGHER INTEREST RATES
Overdraft facility comes with a cost. The cost is usually higher than the other sources of borrowing. Also, if one goes above or exceeds the overdraft limit, the charges thereby are much higher.
THE RISK OF REDUCTION IN LIMIT
Overdraft facility is a temporary loan and undergoes regular revisit by the bank. Hence, it runs a risk of a decrease in the limit or withdrawal of the limit. The withdrawal of limit may happen usually when company financials may represent poor performance; hence, the facility may be withdrawn largely when the company may require it the most.
RISK OF SEIZING
Bank overdraft facility may at times be secured against inventory or other collateral like shares, life insurance policies etc. The company may run a risk of those assets being seized if it fails to meet payments.
DEBTOR’S COLLECTION BECOMES LETHARGIC
At times, availability of overdraft facility may make the company less strict on the collection of debtors’ payment. In other words, a company may not be too much on their feet to collect payments from debtors, as immediate payment outflows can be managed by overdraft facility.
Conclusion:
Overdraft is a temporary facility obtained by the companies to meet their ultra-short term cash shortage/requirement. One needs to bear in mind that such facility comes with a high cost and should be used as a stop-gap management of funds or as an emergency activity rather than a routine funding activity. Higher dependence on overdraft for working capital management indicates poor working capital management and a liquidity constraint faced by the company. Only temporary working capital should be financed by bank overdraft. The permanent working capital should be financed by long term loans having lower interest rates.
