Overdraft is the amount of money by which withdrawals exceed deposits on an account. It is also sometimes called “going into red” because the amount of money on the checking account in the case of overdraft is presented by using the color red. In modern banking, overdraft is considered a form of credit (or a short-term loan) and as such it is one of the basic financial products. Banks pre-approve certain amounts of money that may be withdrawn from a person’s or company’s account (amounts greater than the amount of money on the account) based on the person’s or company’s income and credit rating. If you withdraw more money than you have on your account, you pay monthly interest on the amount overdrawn and the interest rate is larger than the Bank Base Rate. The loan is being covered by monthly deposits. Just a word of a advice – If you are starting your business and using loans, you want a fresh clean slate. Take care to ensure that you monitor business credit lines monthly so you do not have to overdraft due to lack of vigilance.
Although it should be used for short-term financing only, overdraft can be turned into a mid-term loan through constant renewal of the loan, depending on the agreement between the client and the bank.
While overdraft can make cash-flow more smooth and consistent and enables you to “have” some reserve cash if needed, there are some drawbacks. The three biggest would be that:
1. Such financing is rather expensive. The interest rates are usually considerably higher than for a standard loan and in some banks there are also fees to pay just for having the overdraft option available because it increases the amount they have to have in reserve.
2. The amount overdrawn depends on your cash-flow and therefore it is difficult to plan payments and further cash-flow. With a loan, payments are more or less constant and further cash-flow is easier to plan.
3. The bank can demand repayment of the amount loaned any time they want. Which is usually at the worst possible time for you.