Overdraft Advantages And Disadvantages: Definition And Types

An overdraft is a lending facility linked to your bank account with a predetermined limit. It is available at any moment and is most useful for day-to-day spending because it allows you to manage your cash flow more freely. With this,   we look over to the Bank Overdraft advantages and disadvantages

Overdraft Advantages And Disadvantages

Loans, it should be noted, are probably better for long-term funding. An overdraft is more expensive than a loan for a long-term purchase.

The Advantages of an Overdraft

An overdraft is more flexible than a loan because you only borrow what you need at the moment, which may make it less expensive.

It’s simple to set up.

There is usually no penalty for paying off an overdraft earlier than intended.

The Disadvantages of an Overdraft

If you need to prolong your overdraft, you will normally be charged an arrangement fee.

If you exceed your overdraft limit without approval, your bank may charge you.

The bank has the power to request a repayment of your overdraft amount at any moment, though this is rare unless you experience financial hardship.

Overdrafts can be safeguarded against commercial assets.

Overdrafts, unlike loans, can only be obtained through the bank with which you have a current account. You must transfer your company bank account in order to obtain an overdraft elsewhere.

The interest rate charged is almost always fluctuating, making it difficult to assess your borrowing costs precisely.

Not using overdraft facilities may be cut at short notice by banks. Though this is unlikely unless you run into financial trouble,

Keep in mind that what appears to be a good offer may change, as may your company’s demands. It’s a good idea to go over your selections on a regular basis.

The Advantages And Disadvantages of a Bank Overdraft 

The following are the bank overdraft advantages and disadvantages but are on list one at a time. Let’s go!

The Advantages of a Bank Overdraft (Will list Disadvantages below)

A bank overdraft is usually the best option for firms that need to move more cash in a short period of time. An overdraft can help restart a stalled cycle of cash input and outflow rotation. In other words, if sales proceeds and purchases result in a flow of money in and out multiple times during a week/month. An overdraft facility provides for the management of cash flow gaps that may emerge as a result of a timing mismatch.

#1. Assists in Keeping a Good Track Record

If a check was written with the expectation of receiving a certain amount, and the payment is delayed. The check does not bounce due to a lack of cash. As a result, having an overdraft option allows for better payment history.

#2. Payments made on time

It also enables timely payments and the prevention of late payment penalties because payments can be made even if the account does not have a sufficient balance.

#3. Less of paperwork

Because overdraft facilities are readily available, they necessitate less paperwork than is often necessary for long-term loans.

#4. Flexibility

Overdraft facilities provide flexibility because they can be used at any time, for any amount (up to the maximum set), and for as little as one or two days.

#5. Advantage of Lower Interest Rates

The interest rate is based only on the quantity of cash utilised. This allows for larger savings in interest costs as compared to a traditional loan obtained for a set length of time. In contrast, in other loans, interest must be paid even if the money is not used. In this situation, the charging of interest begins with the overdrawn amount and ends immediately when it is paid off.

Bank Overdraft Disadvantages

There are advantages and disadvantages to bank overdrafts, but below are the disadvantages

#1. Increased Interest Rates

Overdraft protection comes at a cost. The cost is sometimes higher than the cost of borrowing from other sources.

#2. Risk of Limit Reduction

The overdraft facility is a short-term loan that is reviewed on a regular basis by the bank. As a result, there is a possibility of the limit being reduced or removed. Reducing the withdrawal limit is common when the company’s financials show bad performance; hence, the facility may be revoked, especially when the company needs it the most.

#3. Possibility of Seizing

Bank overdraft facilities are sometimes secured against inventory or other collaterals such as shares, life insurance policies, and so on. If the corporation fails to make payments on time, those assets may be seized.

#4. Debt collection has become sluggish.

The existence of an overdraft facility may cause the corporation to be less stringent in collecting creditors’ payments at times. In other words, while immediate payment outflows can be address by an overdraft facility, a company may not be too far behind in collecting payments from creditors.

What is the difference between an overdraft and a cash credit?

Overdrafts and cash credit are popular external sources of funding for short-term borrowing at a fee. Businesses employ cash credit and overdrafts to manage their short-term working capital needs. The distinction between overdraft/bank overdraft and cash credit is based on a variety of factors such as the nature of the account, charges and fees, quantity, purpose, type of security, use of money, interest rate, and so on.

Both of these facilities are repayable on demand and hence fall under the category of sources of financing payable on demand or loans payable on demand. However, these facilities are rarely recall in real-life scenarios. Except in extremely rare circumstances such as when a customer’s business and financial position deteriorates over time. Or when the value of the security is discover to be extremely low during period re-valuation of the security or during facility renewal.

What will my overdraft limit be?

The overdraft limit of an individual or a business is determined by a variety of criteria. Most banks offer overdraft protection, however, they determine your overdraft limit based on characteristics such as your age, earnings, credit score, length of association with the bank, and so on. The amount of overdraft limit that a bank will grant you is entirely at the discretion of the bank, and the customer has no influence in the matter, but they may be able to negotiate better terms.

Fees and Charges for Overdraft Facilities

Bank overdraft fees and charges come in a variety of forms. All of these fees change from one bank to the next. The following are some of the fees that may be levied on an overdraft –

For as long as the account is overdrawn, interest is based on a percentage of the amount overdrawn.

Some banks may levy a daily fee on overdrafts until they are in for reimbursement to the bank. There may be other alternatives to this, such as a weekly cost, a monthly price, or all three. These costs are often scaled based on the amount overdrawn.

Banks may also impose a one-time setup fee to begin the overdraft facility.

Overdraft fees are put in by determining with a variety of criteria. Including bank policy, the borrower’s credit score, collateral availability, client loyalty, and so on. It is possible that the same bank will give two separate customers different rates of interest on overdrafts. This facility is totally in for customize.

Types of Overdraft Facility

There are primarily two types of overdraft facilities:

Overdraft Authorized or Agreed Upon

When an account owner has already requested an overdraft and the bank has approved the request, then overdraft is an authorized or agreed overdraft. The account user has the ability to withdraw funds up to the set limit based on predetermined interest and charges.

Unauthorized or unintentional overdraft

There may be times when the account holder does not use the overdraft option. He may, however, want to make more money from the current account than the current balance. If the account holder attempted to make a payment and there were insufficient funds, one of two things could occur:

The bank will either reject or accept the payment.

The bank will punish the payment and consider the payment request to be an unlawful payment.

Unarranged overdrafts will be granted by the bank based on their bank policy and the credit score of the account user. When compared to an authorized overdraft facility, the interest rates and other costs on an unarranged overdraft are typically very expensive.

The overdraft facility can alternatively be classified using the following criteria:

Secured Overdraft: An overdraft arrangement backed up by assets committed to the bank.

Unsecured Overdraft: An overdraft arrangement that does not require security.

In Conclusion

To begin, we must recognize that an overdraft facility serves a very specific purpose for a company or individual. Because such initiatives are pre-planned, an entity may make an informed judgment about whether it needs a bank loan or not. But what about unforeseen expenses and a cash shortage in the day-to-day operating cash cycle? These cannot be planned for, nor can they be financed. Overdraft is the sole option for taking preventative steps for such charges. It acts as a buffer in times of turbulence.

Overdraft Advantages And Disadvantages FAQ’s