Definition of Overdraft Facility

An overdraft facility is a financial service provided by banks that allows account holders to withdraw more money than is available in their account up to a pre-approved limit. This facility acts as a short-term credit option for managing temporary cash flow shortages.

For example, if a person has $500 in their account and an overdraft limit of $1,000, they can withdraw up to $1,500, subject to interest and fees.

Purpose of an Overdraft Facility in Banking

An overdraft facility serves multiple purposes, including:

• Providing short-term financial flexibility.
• Preventing declined transactions and insufficient fund fees.
• Helping businesses manage working capital and unexpected expenses.
• Covering emergency expenses without requiring a loan application.
• Offering a revolving credit line for both personal and business accounts.

How an Overdraft Facility Works

Approval and Overdraft Limit

• Banks approve overdraft limits based on income, account history, and creditworthiness.
• Example: A bank grants a business a $5,000 overdraft facility based on its cash flow.

Interest and Fees

• Overdrafts typically have interest charges on the amount used, often calculated daily.
• Some banks charge an annual fee for maintaining an overdraft facility.
• Example: A person overdraws $200 for 10 days at an interest rate of 15 percent per year, resulting in a small interest charge.

Repayment and Overdraft Usage

• Overdrafts are repaid automatically when funds are deposited into the account.
• Banks may set minimum repayment requirements or charge penalties for prolonged overdrafts.
• Example: A salary deposit clears an overdraft balance, restoring the account to positive.

Types of Overdraft Facilities

Secured Overdraft

• Backed by collateral such as fixed deposits or property.
• Example: A business pledges inventory as security for a $50,000 overdraft.

Unsecured Overdraft

• Provided without collateral but based on creditworthiness.
• Example: Based on account history, a high-income professional qualifies for a $2,000 unsecured overdraft.

Authorized Overdraft

• A pre-approved facility with a set limit and agreed-upon terms.
• Example: A company negotiates a $10,000 authorized overdraft for seasonal expenses.

Unauthorized Overdraft

• Occurs when withdrawals exceed the overdraft limit, leading to high penalty fees.
• Example: A customer exceeds their overdraft limit by $100 and is charged an extra fee.

Overdraft Facility vs. Personal Loan

Feature	Overdraft Facility	Personal Loan
Definition	A short-term credit line linked to a bank account	A lump sum loan repaid in fixed installments
Interest	Charged only on the amount used	Charged on the full loan amount
Repayment	Flexible, repaid when funds are available	Fixed monthly payments
Example	A business uses an overdraft to cover payroll temporarily	A borrower takes a $10,000 personal loan for a car purchase

Example: A business may use an overdraft to cover short-term expenses, while a personal loan is better suited for long-term financial commitments.

Advantages and Disadvantages of an Overdraft Facility

Advantages

• Provides immediate access to extra funds when needed.
• Interest is charged only on the amount used.
• Helps avoid declined transactions and late payment penalties.

Disadvantages

• Interest rates can be higher than other forms of credit.
• Overuse may lead to financial dependence and high costs.
• Banks may withdraw overdraft privileges if account conditions change.

Related Terms

• Credit line – A revolving loan limit that can be borrowed and repaid multiple times.
• Insufficient funds – A situation where a transaction is declined due to a lack of balance.
• Working capital – The funds available for daily business operations.

Interesting Fact

Many businesses rely on an overdraft facility as a short-term funding solution, with banks approving overdrafts based on cash flow and account activity rather than traditional credit scoring.

Statistic

According to the Bank of Canada, over thirty-five percent of Canadian small businesses use an overdraft facility at least once a year to manage short-term cash flow challenges.

Frequently Asked Questions (FAQ)

1. How do I qualify for an overdraft facility?

Banks assess account activity, income, and credit history before approving an overdraft limit.

2. Does an overdraft affect my credit score?

Yes, excessive overdraft use or failure to repay can impact credit ratings, especially for unsecured overdrafts.

3. What happens if I exceed my overdraft limit?

Banks may charge penalty fees, higher interest rates, or decline further transactions.

4. Can I increase my overdraft limit?

Yes, banks may increase limits based on financial stability and account management history.

5. Is an overdraft facility better than a credit card?

It depends on usage—overdrafts offer flexible short-term credit, while credit cards provide structured repayments and rewards.