Overdraft

Page written by AI. Reviewed internally on July 19, 2024.

Definition

An overdraft is a financial arrangement provided by a bank or financial institution that allows an account holder to withdraw or spend more money than is currently available in their account, up to a specified limit.

What is overdraft?

Overdraft essentially provides short-term credit to cover temporary shortfalls in funds. Overdrafts can be a useful financial tool, but they come with associated fees and interest charges.

When an account is set up, the bank may offer an overdraft facility with a predetermined limit. If the account holder withdraws or spends more money than is available in their account, the overdraft comes into effect. The account balance goes below zero, but the overdraft covers the shortfall, up to the agreed-upon limit.

The bank typically charges interest on the overdrawn amount, often at a higher rate than for other loans or credit products. The overdraft is expected to be repaid within a specified period, which may vary depending on the bank’s policies. 

An advantage of overdraft is that it provides quick access to additional funds, which can be crucial in emergencies or for covering unexpected expenses. Furthermore, An overdraft can prevent checks from bouncing, which could result in additional fees or damage to the account holder’s credit score.

When considering overdraft it’s important to consider the risk associated with it. Overdrafts can be expensive due to high interest rates and associated fees. Furthermore, the account holder is responsible for repaying the overdraft according to the terms agreed upon with the bank. Failure to do so can lead to further fees and potential damage to creditworthiness.

Example of overdraft

Let’s say Company XYZ operates a small manufacturing business. Due to seasonal fluctuations in sales, the company occasionally experiences cash flow shortages. To address this issue, Company XYZ has a business checking account with a bank that offers an overdraft facility.

During a slow sales period, Company XYZ’s checking account balance falls below zero due to outgoing payments such as payroll and utility bills. However, because Company XYZ has an overdraft arrangement with the bank, which allows the company to continue making payments even when there are insufficient funds in the account. The bank covers the shortfall temporarily, effectively extending credit to the company.

In this scenario, the overdraft acts as a short-term financing solution, providing Company XYZ with the flexibility to meet its financial obligations during periods of reduced cash flow.

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