What is Overdraft? Definition, Concepts, Pros and Cons

Overdraft is a banking term that refers to the withdrawal of money from a bank account even after there is no money left. Usually the provision of an overdraft facility is provided to the customer when the account is created, wherein an overdraft limit is set.

The amount overdrawn is to be within a set limit, and interest is charged at a fixed rate on the amount overdrawn. In case the amount overdrawn exceeds the limit then higher interest charges are levied. Essentially, overdrafts may be considered as very short time individual loans.

Key Takeaways

1. Overdraft is a financial facility that allows an individual to withdraw more money than they have in their account.
2. The bank provides a short-term loan and is subject to interest charges and fees.
3. An overdraft can be useful for emergencies but should be used responsibly to avoid debt.

Understanding the concept of overdrafts

The best example to understand the concept is to consider a situation where you require withdrawing more money from your bank account than there is available, or you are required to write a cheque to someone even though you have negative balance. The bank then covers this charge with their discretion according to contractual and signed obligations. They typically also charge a fee for the same.

Thus, overdrafts are:

1. An extension of credit by the bank to be availed of ideally only in emergencies.
2. A regular feature in corporations and businesses in which multiple parties are involved.
3. A temporary solution that may end up costing more than anticipated because of the interest charged and the overdraft fee.

Advantages of overdrafts

1. Overdrafts are generally of lesser value than loans and easier to pay off.
2. There is also a degree of flexibility when it comes to the time period within which you have to pay off your overdrafts.
3. There is no hassle of arranging collaterals or other papers because this is a simple service offered to you by the bank.
4. You can avoid other fines incurred by unpaid bills by taking out an overdraft and taking care of several billing needs for the time being. This will help you to avoid several fines and charges at once while allowing you to pay it off all at once to your bank at a later time.
5. You can link your overdraft to a credit card, in which case it will only increase your debt amount.
6. In certain unforeseen or special circumstances, banks have been known to personally pay off overdrafts themselves for certain customers.

Disadvantages of overdrafts

1. Substantial amounts can be incurred by an individual while taking an overdraft, often not to their knowledge.
2. The provision of regular overdrafts creates irresponsible banking habits on the part of customers who prefer short term borrowings to stay financially afloat or meet other payment deadlines.
3. Overdrafts may be taken from only the bank where you contain your account. Unlike loans, you cannot apply to other banks without first moving your bank account. This is not conducive if you are away in another city and require an immediate overdraft.
4. Unlike loans, interest rates tend to fluctuate and you may not be aware of how much you are actually investing at the time of availing of the overdraft facility.

References

1. https://www.tandfonline.com/doi/abs/10.2753/JEI0021-3624450212
2. https://heinonline.org/HOL/LandingPage?handle=hein.journals/waslee69&div=30&id=&page=