An overdraft facility provided by a lender such as a bank or non-banking financial company is a type of loan which you borrow up to the limit permitted through your account with the lender. It basically means that you can withdraw extra money from your bank account; more money than what you have in there and when you repay the money, you will also have to pay interest on the amount you borrowed. Please note that the interest rate levied on the borrowed amount in this case is fixed and not floating.
How to apply for Overdraft facility?
As aforementioned, borrowing through overdraft is just like borrowing a loan from the bank. Some customers are pre-entitled to avail the overdraft facility by the lender (bank or NBFC) while some have to take approval. When the pre-entitled customers withdraw extra money from their account, their outstanding goes positive and the overdraft facility is activated automatically. The customers who require the lender’s approval to avail the overdraft facility have to submit their request to their lender either in writing or through the internet banking portal. Overdraft taken against bank account is considered unsecured overdraft while the overdraft where collateral is pledged is considered secured overdraft. Many banks charge a processing fee to the tune of up to 1% to provide their customers this facility.
What are the advantages of Overdraft facility?
Overdraft is a credit facility which you can use in a time of financial emergency. In a loan, when you borrow a payment schedule is set and you have to pay as per that payment schedule. If you want to prepay a loan, usually a prepayment charge is levied.
However this is not the case with the overdraft facility. When you repay the amount borrowed through overdraft you do not pay prepayment charges. Also you need not repay the Overdraft in EMIs. You can repay the borrowed amount cumulatively. The interest is calculated for the time you had the borrowed amount. Through the overdraft facility you can finance your short-term needs. The overdraft facility is usually cheaper and more easily accessible than loans.
How does an Overdraft account work?
If you get an overdraft account sanctioned from the bank then you will receive the requested overdraft amount just like you receive a loan amount from the bank. If you are pre-approved for the overdraft facility, whenever you need funds, you can withdraw from your bank account and it will go into overdraft. You can overdraw funds through your account up till an agreed limit. By utilizing the overdraft facility you basically increase the outstanding on your bank account; when you deposit funds, the outstanding decreases. From the time you borrowed until you repaid, you will be charged interest by your bank.
In an overdraft, you can repay money to the lender, fully or partially both, whenever you want to. After repaying whenever you have money, you can again withdraw money from your account as per your need until the limit of the overdraft is reached.
When a borrower uses the overdraft facility through his/her bank account, the bank doesn’t have collateral against it. However, if the borrower takes an overdraft against his/her assets as collateral then it is a secured overdraft. These assets can be the funds in your account and even your house, insurance policies, fixed deposits (FDs), shares, bonds etc. Also note that the interest rates charged and overdraft amounts sanctioned by banks vary depending on the collateral.
Interest on the overdraft amount is calculated daily because overdraft amount is not repaid as per a set schedule. The borrowed amount can be repaid without prior intimation by the borrower. Just depositing funds in your bank account reduces your outstanding balance and thus reduces your overdraft amount. So, interest applicable on the borrowed amount needs to be calculated daily since the borrowed amount ledger can change daily.
Thus, one can say that interest on an overdraft account is calculated daily on the fluctuating outstanding balance. However, this daily interest amount is added for the month and is only seen in as a cumulative in the monthly account statement. Please note that the overdraft interest rate is linked to the bank’s prime lending rate.
List the Indian Banks which provide Overdraft facility
All banks and many non-banking financial institutions provide the Overdraft facility.
List the different types of Overdraft Collaterals
As aforementioned, availing the bank’s overdraft facility is similar to availing loans from banks. An overdraft facility can be granted to a borrower on a secured or unsecured basis. Secured overdraft is one where you pledge collateral (asset). If you are unable to repay your overdraft then the lender can sell off your assets to recover whatever they can. You shall be liable to pay the difference if the collateral asset doesn’t cover the cost of the withdrawn amount in the overdraft.
An unsecured overdraft is then obviously the facility where no assets are pledged as collateral security. An unsecured overdraft facility is usually availed when a customer carries out a transaction which makes his/her outstanding positive, i.e. when the customer draws more money than what he/she has in the account. A common example of an unsecured overdraft is Credit Cards. Anyway, secured overdrafts employ collaterals and they can be of different kinds; know the types below-
Overdrafts against House: Overdraft facility is offered against your house as collateral. Overdraft is also offered to home loan customers who are looking for funds to settle their existing home loan repayments. Before approving the house as collateral, the assessment, the valuation and the survey of the property is done. Overdraft funds given against property as collateral are not disbursed immediately because of the same. The sanctioned overdraft amount is usually up to 50% or 60% of the property’s worth. Your credit history and repayment capacity is also considered while granting overdraft against house as collateral.
Overdrafts against Fixed Deposits: Getting the overdraft sanctioned against Fixed Deposits (FDs) and life insurance policies as collateral is easy in comparison to getting an overdraft sanctioned by keeping your home as collateral. One of the reasons is that property evaluation takes time. In any case, overdraft against FD is preferable for the lender too as the customer’s FD account is with the lender and the lender knows the customer much better. If you avail an overdraft against your fixed deposit, then you are eligible for a higher percent of sanctioned amount, approx. 70%. Interest rate charged is also less if you keep FD as collateral. Usually banks charge 1% more interest than the interest you are earning from the said fixed deposit if you keep the FD as collateral.
Overdrafts against Insurance Policy: If you keep your insurance policy as your overdraft collateral then the sanctioned amount depends upon the surrender value of your insurance policy. The Loan to Value of insurance policy is greater than LTV of Fixed Deposits, i.e. you get more money sanctioned from the bank if you keep your insurance policy as collateral rather when you keep your FD of the same amount as collateral.
Overdrafts against Equity: Equity is not preferred as an option for collateral however it is possible to attain overdraft facility through it. The reason being that equity is dependent on the market and thus its value fluctuates. This is why the percent sanctioned for overdraft against equity as collateral is less.
Overdraft against Salary: Banks offer overdraft against your salary too. You can usually avail 50% of your in-hand salary amount as overdraft amount. To avail such an overdraft you need to have a salary account with the said bank. Such facility is also called a short-term loan facility.
What are the features of Overdrafts?
- Approved Credit Limit: Overdraft is awarded over a predetermined limit. This limit can be different for each borrower.
- Repayment is not done through EMIs: Repay the overdraft whenever you have the money. You do not have to repay the overdraft amount like you repay a loan. You do not have to repay in Equated Monthly Instalments (EMIs). You can repay whatever amount you like whenever you like. However if the lender demands a repayment, then you will have to fulfil that demand.
- Minimum Monthly Payment: Overdraft has no minimum monthly repayment however the amount you owe should be in the overdraft limit. You should not delay overdraft repayment for long as it affects your credit score.
- Joint borrowers are allowed on Overdraft: If you take an overdraft jointly then you and your joint applicant are both, in effect, responsible for the entire debt. Irrespective of the proportion of overdraft borrowed, both the applicants are responsible for the timely repayment of the overdraft. This means that if one of the borrowers is unable to pay/defaults, then the other borrower has to pay the entire amount. In such a case, irrespective of overdraft proportion of joint borrowers, all collaterals of each of the borrower are at stake if default occurs.
- Interest: As you already know, interest is charged on the amount of overdraft used. It is calculated on daily basis and it is billed to the account at month-end. If you default on paying the overdraft as per set schedule, the interest amount will be added to the principal amount at month-end and then interest will be calculated on new principal.
- Workings: Please note that your account may not automatically go into overdraft when you write a cheque. There are chances that your cheque is dishonoured instead of going into overdraft and then a dishonour charge may be levied on your account. Overdrafts are short-term loans and thus are preferred by professionals rather than businesses. You can withdraw from the overdraft account as and when you require funds. Overdraft is like an approved loan. However this is not the case with loans. You usually get the entire amount all at once except in case of home loans for under-construction properties.
As explained the overdraft facility is just a revolving short term credit facility. Avail it if you need funds in an emergency situation and return them ASAP so that your interest pay-out doesn’t pile up.