Definition of overdraft: A short term borrowing facilility, with a pre-agreed borrowing limit, which is repayable on demand
What is an overdraft?
An overdraft is a short term, unsecured bank loan. What makes an overdraft different from other short term loans, is that the loan is automatically drawn down if the bank balance falls below zero.
Both small businesses and individuals are eligible to request an overdraft facility with their bank.
Large businesses can also access similar arrangements, although these are known as ‘revolving credit facilities’ and come with additional restrictions and covenants. Financial accounting books may also refer to overdrafts as unsecured borrowings which are payable on demand.
How does an overdraft work?
Arranged overdrafts are purposeful affairs. Both the bank and customer will agree upfront that an overdraft facility should be established.
The bank will examine the credit risk of the customer and place an upper limit on the maximum borrowing level that it can make available.
The interest rate or charges will also be agreed upfront.
The charges for overdrafts vary by bank. Some charge an interest rate based on an Annual Percentage Rate (APR) e.g. 29.9%.
Others charge no interest but instead levy a fixed daily charge for each day that at least some of the overdraft facility is being used, e.g. £1 per day.
An interest rate is helpful for customers who may only use a small element of this overdraft limit, as the interest which accrues will be proportionate to the small sum borrowed.
Daily charges are helpful for customers who have withdrawn the maximum balance, as this charge could work out as a lower % of the amount actually withdrawn. They’re also easier to predict and calculate.
To use an overdraft, the customer merely has to let their bank account slip into negative territory. When the account is below zero, the negative balance represents the size of the loan.
Overdrafts are technically repayable on demand. This means that the bank can recall the overdraft entirely at its discretion. If the customer is unable to pay, then the bank could begin its payment collection process.
This makes overdrafts inappropriate for long term uses, such as home improvements or to buy a car. Overdrafts tend to be used for very short term cash-flow issues such as a surprise bill, which will be resolved on the next payday when the income will move the account back into credit.
Are overdrafts risky for a bank to offer?
As an overdraft is unsecured, it is higher risk than a secured loan such as a debenture. Secured loans result in a ‘charge’ placed over an asset such as property or piece of equipment. This gives the bank the power to seize that asset to recoup a payment if the customer defaulted.
Overdrafts come with no such security for the bank. However, the bank is in the fortunate position of being the gatekeeper of cash receipts into the business, which puts it in a more privileged position than other lenders such as bondholders.
What is an unauthorised overdraft?
When the balance of a customer without an arranged an overdraft goes below zero, a bank has two choices:
- It could refuse to honour any payments that would take the account below zero. This is known as letting the payments ‘bounce’. Any businesses or individuals who had requested payment through direct debit, cheques will be informed that the payment failed to be taken.
- Alternatively, it could honour the payment request, allowing the customer’s bank balance to fall below zero. This creates an ‘unauthorised’ overdraft.
The charges for unauthorised overdrafts are traditionally much higher and usually take the form of daily charges rather than an interest rate. This is to protect the bank from a credit risk which it has been forced to take on which it did not have the chance to review in advance.
Considering that the size of an unauthorised overdraft might be very small, this is a very profitable activity for banks and has been recently under pressure from UK regulators.
How is the word overdraft used in a sentence?
“The balance sheet shows £0.8m of overdrafts within current liabilities.”
How does the definition of overdraft relate to investing?
When reviewing the financial statements of a company, you may notice overdrafts and other short term borrowings within current liabilities.