Definition
An overdraft is a flexible loan arrangement provided by a bank or building society that permits customers with a cheque account to withdraw more money than what is available in their account up to a specified limit, known as the overdraft limit. The bank or building society charges interest on the daily debit balance. Overdrafts offer a cost-effective borrowing solution compared to taking a bank loan, depending on interest rates, as credits to the account are considered when assessing the interest to be charged.
Examples
Example 1: Personal Overdraft
John has an overdraft limit of $500 on his cheque account. If his account balance is $100 and he writes a cheque for $400, the bank will allow the transaction, and his account balance will be -$300. John will be charged interest on the $300 overdrawn amount until he deposits funds to bring his balance back to at least zero.
Example 2: Business Overdraft
XYZ Corporation has an agreed overdraft limit of $10,000 to manage their cash flow needs. If the company has $2,000 in their account and needs to pay a supplier $5,000, they can use the overdraft. The account balance will become -$3,000, and the company will pay interest on the $3,000 overdrawn until sufficient funds are credited back into the account.
Frequently Asked Questions (FAQs)
What is an overdraft limit?
The overdraft limit is the maximum amount by which a customer is allowed to overdraw their account. This limit is predetermined by the bank based on the customer’s creditworthiness and account history.
How is interest on an overdraft calculated?
Interest on an overdraft is charged on the daily debit balance. The rate of interest can vary and is typically disclosed by the bank when the overdraft facility is first established.
Is an overdraft different from a loan?
Yes, an overdraft allows for flexibility in borrowing smaller amounts up to a specific limit, and interest is usually charged only on the overdrawn amount. A loan, on the other hand, is a fixed amount borrowed for a set period with scheduled repayment terms.
What happens if I exceed my overdraft limit?
Exceeding your overdraft limit can result in additional fees and higher interest rates. It may also cause transactions to be declined, leading to inconveniences such as penalty charges from both the bank and the payee.
Can overdrafts affect my credit score?
Yes, using an overdraft irresponsibly or exceeding the limit can negatively affect your credit score. Proper management, however, may not have an adverse effect and can even demonstrate responsible credit behavior.
Related Terms and Definitions
Bank Loan
A bank loan is a fixed amount of money borrowed from a bank, repayable over a specific period with interest. Unlike overdrafts, loans usually have set repayment schedules.
Cheque Account
A cheque account, also known as a checking or current account, is a type of bank account that allows for withdrawals and deposits, and typically comes with a cheque book for making payments.
Credit Limit
The credit limit is the maximum amount of credit that a financial institution extends to a customer. This can apply to credit cards as well as overdraft facilities.
Online Resources
- Investopedia - Overdraft
- Bankrate - Everything You Need to Know About Overdrafts
- The Balance - What is an Overdraft?
Suggested Books for Further Studies
- “Accounting All-in-One For Dummies” by Kenneth W. Boyd
- “Financial Accounting: An Introduction to Concepts, Methods and Uses” by Roman L. Weil, Katherine Schipper, and Jennifer Francis
- “Overdraft: Saving Your Board—Treasurer—Municipal Bond Trustee And Yourself From Embarrassment And Worse” by John C. Erickson
Accounting Basics: “Overdraft” Fundamentals Quiz
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