How An Overdraft Facility Works And How To Use It Wisely To Not Fall Into A Debt Trap

An overdraft facility can be useful when cash flow is tight, but it pays to understand how it operates and when it’s a good idea to use it.

The majority of people who have a salary or current account will likely be able to access an overdraft without even knowing it. Although the service is convenient in times of financial crises, it can prove costly when used recklessly.

What is an overdraft?

An overdraft is a short-term credit facility provided by banks to accountholders. It enables accountholders to withdraw cash in excess of their balance in the bank account, subject to a limit. Overdraft facility is typically attached to salary or current accounts, and functions as a cushion in times of temporary liquidity shortage.

For instance, if you have a balance of Rs 2,000 in your account and you want to withdraw Rs 5,000 for a medical emergency, the bank may allow you to withdraw the additional Rs 3,000 as a loan and charge an interest on it.

Overdrafts come in two forms: authorised and unauthorised. An authorised overdraft is where the bank pre-approves a specified limit. An unauthorised overdraft occurs when you exceed your limit or use the facility without first obtaining approval from the bank. The latter may incur stiffer penalties.

Who Can Use it?

Banks tend to provide an overdraft facility to customers having a regular income. For salary accountholders, banks link the overdraft facility with the salary account, and for companies or self-employed professionals, such overdraft facility is usually linked to the current account.

The credit limit varies with the average balance held, monthly income, or history in the bank. With some banks, one may be granted an overdraft of three times the monthly salary. In other instances, up to 90 per cent of the fixed deposit amount may be allowed as overdraft on a fixed deposit (FD) held with the bank. In such cases, the overdraft facility will be linked with the FD account.

Zero-balance and low-collateral overdraft facilities are also provided by various public and private sector banks for pre-approved customers. Banks might also provide temporary overdrafts during festival times or for covering short-term business requirements.

Advantages of Utilising Overdrafts

• Fast access to funds: The biggest advantage of an overdraft is that it provides you with easy access to additional money, particularly in case of a medical emergency, sudden trip, or for some other emergency.

• No documentation: As overdrafts are typically pre-approved in most situations, you won’t need to apply for a loan each time you apply for an overdraft.

• Interest on only the used amount: In contrast to personal loans where the interest is levied on the entire amount borrowed as a loan, the interest on overdrafts is charged only on the used amount, and for the duration that you use it.

• Flexible repayment: There is usually no fixed equated monthly instalment (EMI) on overdrafts. You can repay the overdraft amount piecemeal as money comes in, although some banks demand full repayment within a specified period.

Drawbacks to be Aware of

• High Rate of Interest: Overdraft rates are typically higher than that on ordinary loans—usually in the range of 10-24 per cent per annum. Some banks might also charge renewal fees or processing fees on them.

• Can Lead to Overspending: As the money is easily accessible, it can make users spend more than they can repay, and hence, they might risk falling into a debt trap. If payments are missed or if you always rely on your overdraft, it can have a negative impact on your credit report.

• Unsuitable for Long-Term Requirements: Overdrafts are for temporary usage. For long-term financial needs, a personal loan may be a cheaper option.

When Should You Use it?

Only use an overdraft when you are experiencing a short-term paucity of cash and can repay it within a short period. An overdraft facility can prove to be handy in settling bills, meeting medical emergencies, or for meeting urgent expenses just before your salary is due or your cash flow turns regular.

Don’t use an overdraft facility for meeting your regular expenses, shopping, or holidays. Also, monitor your usage and repay the overdraft as soon as possible to prevent high interest charges.

An overdraft facility is a financial buffer—it eases the pain in bad times, and therefore, should be used judiciously only when you absolutely require it. It should not be used as a long-term support system. Understanding how an overdraft works and using it wisely can help you stay afloat and tide over an emergency without getting into a debt trap.