Overdrafts Guide: A Safety Net That Can Trap You

An overdraft is a credit facility that allows you to withdraw more than the balance available in your bank account, up to a limit approved by the bank. Interest is charged only on the amount used, which makes it appear convenient for short-term needs. Unlike loans, Overdrafts do not involve recurring applications, and the funds are available quite instantly, making them popular in situations where cash is required quickly.

The True Cost of an Overdraft

An overdraft is a costlier way of borrowing. Most banks in India charge between 10 and 25 per cent annually. If the overdraft is against a fixed deposit, then it is typically 1 to 2 per cent more than the deposit rate. For instance, taking Rs 10,000 at 15 per cent for a month incurs approximately Rs 125 in interest alone, aside from other charges.

The interest grows rapidly since fees are determined on a daily basis. Renewal fees, processing fees or service charges for maintaining the facility in an open position can be added by banks. In case you go over the sanctioned amount, a penalty rate can be charged.

Global Scenario

In countries like the US, overdrafts function differently. Rather than high annual fees, banks simply charge a flat amount every time an account goes into overdraft. The average charge is between $26 and $35 per overdraft. A customer who overdrafts several times in a month may end up paying more in fees than the actual deficiency itself.

Why Overdrafts are Popular

Overdrafts remain popular due to the ease they offer. They are used by salaried workers to cover expenses until payday. Freelancers and gig economy workers use overdrafts to cope with irregular incomes. Small firms take overdrafts to quickly balance working capital shortfalls. Easy access and lack of documentation hassle make them seem like a cash safety net, even when fees are comparatively higher.

The Hidden Trap

The actual danger is of reliance. Convenient availability makes overdrafts too easy to use for everyday expenses. If borrowers use them as an extension of their wage or income, repayment becomes problematic. With no set payment schedule, balances remain in the red for months, and interest keeps piling up stealthily. Fees and penalties creep up over time, trapping individuals in a vicious cycle in which a short-term fix becomes long-term debt.

Consider the example of a salaried person earning Rs 40,000 per month. If they habitually overdraft Rs 5,000 in the last week of the month and settle only when salary is credited, the interest would appear negligible at first. But doing so month after month means hundreds of rupees lost in interest each year, excluding renewal charges. What seems a harmless buffer gradually nibbles away at savings.

Overdrafts Compared to Other Credit

Their strengths and weaknesses are clearly brought out when overdrafts are compared with other borrowing products:

• Personal loans have lower interest rates and fixed EMIs, although the sanction process is more time-consuming.

• Credit cards may be expensive for cash advances, but they carry advantages such as grace periods, reward points and promotional offers which overdrafts do not.

• Overdrafts provide the most rapid access and flexibility, but will become more costly than either cards or loans if not paid off in a timely manner.

Safe Use of Overdrafts

Overdrafts can be a helpful tool if managed responsibly. The secret is to borrow only as a last resort and to pay back the amount as soon as possible so that daily interest payments do not accumulate. Creating a personal limit which is less than the sanctioned amount by the bank can help prevent excessive spending. Periodic monitoring of bank statements makes sure that surprise fees or penalties are not neglected. Most importantly, overdrafts need to be an infrequent back-up tool and not a frequent source of money.

An overdraft is neither good nor bad in itself. It is a weapon which, in short, sharp doses, can assist, but which, if used as a habit, is bad news. With interest rates of between 10 and 25 per cent and extra charges added on, overdrafts are something to be used with extreme caution. Used once or twice and repaid immediately, they give genuine support. Used over and over, they can leave you entangled in debt that quietly drains your income.