What is an Overdraft Facility: Understanding Flexible Credit Options

An overdraft is a highly flexible credit facility that enables you to withdraw above and beyond the stated bank balance for a specific ceiling or pre-sanctioned limit. Interest is paid largely on the amount drawn and the duration the overdraft was outstanding. Overdrafts (OD) in India may assist in bridging temporary cash flow shortages. They tend to be a more effective solution to a temporary need than long-term finance.

Quick Read

• The overdraft facility could be backed by an asset like a fixed deposit or property or would be given as per one’s salary or banking relationship. 

• Each OD facility varies according to, among other things, any collateral it is based on, salary, and account history. 

• The bank will assess the income, account history, prior commitments, and creditworthiness of the applicant while sanctioning the loan. 

• By having knowledge of the repayment facility, renewal, and charges that apply, the borrower may be able to prudently use an OD facility.

Imagine you need to pay out a bill that is due today, but the funds you are expecting to receive will be in your bank account tomorrow. There are many instances like this, particularly when a business has unpredictable cash flow or when unforeseen personal costs arise, where it’s handy to have a bit of financial buffer up your sleeve. This is why familiarizing yourself with overdraft facilities can help you work out whether it's the right type of borrowing for you.

An overdraft loan is a type of loan that allows you to withdraw more money from your account than you actually have, for example, up to your account limit.

With an overdraft, you do not get the full loan amount at once like you would with a regular term loan. Instead, you use the money as needed and pay back what you use based on the bank’s rules. The interest is usually calculated only on the amount you actually utilize for the period of time you use it. 

In our example, had you taken an overdraft up to ₹2 lakh and used only ₹50,000, interest would be charged only on the latter amount.

Understanding how overdraft facility works in India can make it easier to decide whether this type of credit suits your needs. Once a bank sanctions an overdraft limit, you can access funds beyond the available balance in your account, up to the approved limit.

1. The bank determines your overdraft limit according to your eligibility or the collateral you have.

2. You may draw on the funds whenever there is a need on a short-term basis.

3. Interest is charged only for the amount that is used.

4. The amount owed decreases as money is put into the account.

5. The facility could be required to have its renewal carried out after a certain period of time.

It is this flexibility that sets an overdraft apart from a conventional loan having fixed EMIs.

There are usually four popular kinds of overdrafts available with banks in India: fixed deposit-based overdrafts, property-based overdrafts, overdrafts on salary, and unsecured overdrafts. Choose the right overdraft product based on your collateral, income, and lending requirements.

Overdraft Against Fixed Deposit

An overdraft backed by a fixed deposit uses your existing FD as security. Your FD keeps earning interest, and the limit you get depends on the bank’s rules and the amount in your deposit.

Overdraft on Property

When your property or commercial premises serve as security, you may obtain an enhanced overdraft facility for your business. Because the bank needs to check the property’s value and legal status, approval might take more time.

Salary Overdraft

Some banks in India let eligible salary account holders use overdraft facilities. The limit often depends on your salary, job profile, and how long you’ve been with the bank.

Unsecured Overdraft

A bank will normally do some check for unsecured overdrafts. In the first place, these do not come with collateral, so it will normally demand a consistent salary, good credit, and account history to authorize you one.

Overdraft interest is usually calculated only on the amount you use and for the period during which it remains outstanding, not on the full sanctioned limit.

For instance, if your OD limit is ₹1 lakh but you spend ₹40,000 over ten days, interest will generally be charged on the amount of ₹40,000 for those ten days, on the basis of the bank's relevant rate and terms.

It can therefore be useful to have an overdraft when facing short-term funding gaps. Yet if the amount remains outstanding for a long time, then the total cost of the borrowing will increase.

Banks in India set an overdraft limit by looking at your financial profile, ability to repay, banking history, and any collateral you can offer. They may consider factors such as:

• Value of collateral, for secured overdrafts

• Monthly income and repayment capacity

• Banking and account transaction history

• Existing loans and financial obligations

• Credit profile and repayment behaviour

• Relationship with the bank

Banks might also take into account the cash flow patterns and the financial position of a business when assessing such loans. The amount of the final limit will depend on the bank's internal policies and the borrower's overall profile.

Before you use your overdraft, be sure you’re familiar with the interest rates, fees, your repayment terms, and how much that overdraft will actually cost you.

Consider:

• Interest rate and calculation method

• Processing or renewal charges

• Repayment terms and penalties

• Collateral requirements

• Cost of prolonged utilisation

Leaving an overdraft in place for a long time without having a repayment plan can result in the cost of borrowing becoming high.

With an overdraft, you can use money up to a certain limit any time you need it, whereas a traditional loan provides you with a single sum, which you then repay according to a fixed schedule.

*The best choice depends on how much money you need and how long you plan to use it.*

An overdraft can be helpful when money is expected to come in soon, but an expense cannot wait. Still, easy access to funds should not mean borrowing without thinking it through. Knowing the interest cost and having a rough repayment plan can save trouble later.

At Finnable, we understand that financial needs don’t always come with a warning. With this in mind, we feel it's wise to stop and think about the financial state you're in before taking out credit. Whether you have an unexpected bill to pay or a short-term need in your cash flow, what matters is that you select a loan that you're capable of repaying. Having cash on hand quickly can fix your problem today, and getting it the right way can have a calming effect on tomorrow.