Banks allow you to dig deeper into your account even if it is already empty, but would that be okay for your finances?
The key to understanding overdraft facility is defining both words first: facilities are short term loan financial assistance offered by banks to existing customers — either companies, small businesses, or individuals who are currently struggling and would need some assistance.
The overdraft on the other hand is a mechanism where banks extend credit when the account is emptied or reaches zero.
To cut things short, a facility is a revolving loan. It is an agreement between the bank and the borrower that allows the customer to overdraw his or her current account up to an agreed limit — known as the overdraft limit — and at an agreed interest rate.
How an Overdraft Works
It begins when a bank’s customer tries to make payments exceeding the account’s current finance. Say, for example, you write a check worth $2,000 for something, maybe a rent payment or to settle other liabilities, but you only have $1,800 inside your account.
You can correct that with a facility, wherein banks or lending institutions give you what you lack — in this case, $200 — instead of denying payment or issuing an insufficient funds statement.
This helps especially as having insufficient funds can sometimes take a toll on your payment record.
To avail of the facility, you can either discuss the terms with your bank, specify how much you need, and comply with the requirements that they would ask for. For individuals, banks usually require bank statements for three months, proof of income, and other things like details of why you needed to apply for an overdraft.
In some cases, accounts already have protection where they are immediately shielded from running out of funds without even going to banks and other lending firms to apply.
Advantages & Disadvantages
- It saves borrowers from not having money during emergencies and other circumstances.
- Application is also considerably easy, and most banks and lending institutions actually offer overdraft services and protection.
- If you no longer want to use it, you can close the facility even during the duration of your personal loan payments.
- Avoiding bouncing checks which may provide a bad record and unexpected penalties.
- Having another set of liabilities to settle.
- Customers can expect to pay interest (additional) that may actually have interest higher than the loan itself.
- Overdraft facilities can actually be closed by banks for the simplest of issues while defaulting on overdraft also means high penalty payments.
- For both corporations and individual applications, overdraft facilities may make it appear that your finances are doing okay when in fact it is only secured by bank assurances that you can pull out money beyond zero balance.
- This then prevents you from pinpointing and addressing the issues with your finances — which means that your business growth and you yourself may go bankrupt.
Types of Overdraft
Secured overdraft facility and unsecured overdraft facility — also have something to do with the advantages and disadvantages these present.
With an unsecured overdraft facility, you do not need to place one of your assets as collateral in case you default on paying the overdraft. But of course, there are limitations to how you can make your overdrafts unsecured — you have to pass a bank’s standards like having a minimum annual salary of $30,000.
While it may be easier to avail for a secured overdraft facility, the disadvantage is that bank/s can immediately seize or sell your assets like cars, properties, and other expensive items once you default on payments.
Fees and Charges
The reason why some financial experts suggest, on some occasions, getting a new loan instead of applying for an overdraft facility is that the latter may be more practical depending on how much you need.
If you are looking for an overdraft of a few hundred dollars, that may be fine but if you are seeking thousands, then you may have a problem: overdrafts obviously contain payments separate from the loan you are settling now.
It might be late before you know that you are in a debt cycle — because after paying the overdraft, there is a huge chance that you would have to go for another overdraft because you paid higher expenses.
Remember that overdraft sometimes puts a charge which goes on top of the interest rate and the repayments.
Different bank/s place different rates and charges, but these three elements are almost constant in an overdraft facility:
- penalty interest charge or the interest that covers the amount you went beyond a zero account
- interest charges based on the amount pulled and computed on a daily basis
- and additional fee/s like chequebook fees
Basically, overdrafts are like lines of credit where you are only charged for the amount of cash you withdrew. Also, repayment is not regular, although you can make payments for the overdraft anytime.
What’s the Difference Between an Overdraft and a Personal Loan
The difference is simple: with personal loans, a client borrows a fixed amount of working capital with a set interest rate/s and payment periods. All borrowed financial help is transferred into your account.
But if you have to apply for a personal loan which may take a couple of days or even weeks, an overdraft is readily available to existing bank clients provided an applicant meets the standards set.
With an overdraft, you are essentially borrowing way past the amount allocated to your account, as overdrafts are used when your balance turns zero. This is not the case with personal loans — once you consume your limit, all that’s left to do is pay.
As mentioned earlier, overdrafts can be paid anytime and have varying interest rate/s which depend on how much was used as an overdraft. Interest rates tend to be higher than the existing loan, plus there are other fees not found in a personal loan.