What is a bank overdraft account and when to use it

An overdraft account is a credit service a bank provides that allows the account holder to withdraw more funds than they have, such as writing an Rs. One lakh cheque from an account with no balance. This article will explore when it’s appropriate to use an overdraft account.

They can be established with fixed deposits (the most popular method) or even against property or income. You may borrow up to 75% of the deposit amount for fixed deposits. The interest rate for this borrowing is usually 1% higher than that of the fixed deposit. The borrowed amount can be taken in parts, and the interest payment starts immediately.

About the author: A commissioned writer from the financial services industry wrote this article. The self-references represent the author, and the views expressed here are that of the author and do not necessarily reflect the views of freefincal.

Disclaimer: Personal finance – being “very personal”, the utility of an Overdraft varies with the profession, lifecycle stage, net worth etc.  A note for readers who are Businessmen, Investors, and Traders: it may be wise to use an overdraft account if you are confident of earning more than the interest you pay for.

I have seen several successful businessmen put their entire working capital as a fixed deposit, take an overdraft against this fixed deposit and then run the operations through the overdraft account. On a personal note, I had followed the same principle of putting all my little capital in a fixed deposit, taking an overdraft against it and then using it towards monthly expenditures and card payments.

There are several use cases for an overdraft account depending on the profile and needs of the individual. This article is mainly for the common man in India. (salaried individuals/small businessmen/professionals).

Types of overdraft

1. Secured Overdraft is available against:

• • Fixed Deposit (except tax saver fixed deposits)
  • Shares
  • Mutual Funds
  • Gold
  • Insurance Policies
  • To existing Home Loan/Car Loan customers.
  • As a home loan variant, ‘ SBI MaxGain’ – Ashal Juahari has done numerous posts on it.

Almost all banks today provide the option of availing an overdraft against a fixed deposit through their net banking/mobile app.

1. Un-Secured Overdraft:

There has been a surge in FinTech companies in India providing unsecured loans/overdrafts. ‘Pay Later’ by tech giants like Amazon, Shopify, and Flipkart is also a kind of overdraft loan. Tech companies view ‘financing’ as a must-have “feature” for the shopping ‘experience’.

 Unsecured overdraft comes at a higher cost.

Interest: The interest(spread) is typically approximately +1% to the FD interest rate. The interest can be negotiated while availing of Overdrafts of higher value, like a crore and upwards.

Charges: Banks in India are generally pretty clean regarding Overdraft against fixed deposit Charges.  Administrative charges are approximately Rs.500/- for a PSU bank. There may be a nominal monthly charge in the event of non-utilization of the OD limit.

 Overdraft charges in News: Toronto-Dominion Bank “TD Bank”, has been fined $122 million by the BUREAU OF CONSUMER FINANCIAL PROTECTION, the USA, for illegal overdraft practices. It was alleged that ‘no explicit opt-in consent of the customers was obtained for allowing OD in their accounts. A study by ‘Center for Responsible Lending’ has shown that big banks combined have charged > $11 billion towards overdraft fees/non-sufficient fund fees from US consumers in 2019. Thankfully, in India, the system seems to be quite transparent as of now. (No wrongdoings has come out so far!)

Who should use an Overdraft Account?

• If you get impatient when you have an outstanding debt.
• If you pay your bills the moment, they come to you.

Someone with the above traits would repay the OD as fast as s/he can.   Such individuals would ensure that their outstanding remains as low as possible.

When should you use an Overdraft Account?

• Financial or Medical Emergency
• Pandemics 🙁
• In non-emergency cases: Use it when you expect the overdraft to return to credit balance (repaying the money) in the short team. You should be confident that you will receive money on an ‘x’ date, but you need money today.
• If you need to borrow money, the Overdraft is turning out to be cheaper than other loans.

Who should not use an Overdraft Account? If you are naturally impulsive and tend to make purchases in a jiffy easily.

When should you not use an Overdraft Account?

• To bet on IPL, play in a casino.
• To loan the money to some distant relatives/acquaintances.
• Consumption purposes: A ‘traditional Indian father’ mindset would advise against using it to buy gadgets, home appliances, travel
• Definitely, DO NOT USE it for long term fund requirements.

Credit card v/s OD account?

• A credit card has an interest-free period; interest on an OD account starts on the same date.
• A credit card has a fixed due date for repayment, OD doesn’t have a ‘repayment’ date as such.

If you keep the above in mind, there will be times when a credit card is more suited, and there will be times when an overdraft account is better suited.

 RBI on overdraft account for Business Loans: For businesses with Overdraft facilities (loans), RBI has asked banks not to open current accounts of businesses that have availed OD loans from other banks. RBI wants to bring in ‘discipline’ among the business community for routing transactions through the loan account. The rationale is: Businesses avoided paying dues even if they had cash flows. This was possible as the business receipts were credited to a different bank account, not the loan account.

In summary, there is nothing wrong with having an active overdraft account.  However, lack of credit discipline may lead the account to be utilized permanently, i.e. it is in debit balance for almost the entire year. Therefore use overdraft only if you are sure of profitable future cash flow from the amount you are overdrawing.