Overdraft

How borrowers can use overdraft facility wisely

Sometimes a contingency fund won’t be enough to take care of a financial emergency. Though most people keep three to six months’ expenses aside as per their financial advisors’ recommendation, they sometimes need to raise money for a short period to meet an emergency.

Many of them turn to their banks for an overdraft against their assets to raise short-term funds. “Overdraft is a good instrument to raise funds for a short term and if used wisely, it can help you tackle your short-term financing needs smartly.

Banks offer overdraft facility to individuals against assets such as property, securities and life insurance policies. The individuals have to pay interest on the amount depending on the period.

What is overdraft?

For the beginners, overdraft facility is a credit line given to an individual against his assets. For example, you can mortgage your house with a bank and get a borrowing limit sanctioned against it.

If your house is worth Rs 1 crore, depending on your repayment capacity and other factors such as remaining life of the property, bank’s rules, bank may give you a limit of Rs 50 lakh.

The money is not disbursed to you immediately. It almost works like an approved loan. As and when you want, you can keep withdrawing money from this overdraft account. You have to pay interest on the money borrowed for the time you have availed it.

You can keep borrowing and repaying your money as long as the bank is willing to offer such overdraft facility to you. The rate of interest payable on such facilities against property usually ranges between 12 and 14% per year.

You can offer the bank assets such as your insurance policies, shares and bonds, bank fixed deposits. The rate of interest does vary for each of these collaterals.

For example, you may end up paying around 12 to 14% for an overdraft against property. Banks charge one percent more than the rate payable on the fixed deposits for the overdraft against fixed deposits.

For example, if your fixed deposits are earning you 8%, an overdraft availed against them will make you pay at the rate of 9% for the period you avail the credit. “This credit facility is secured by an asset and the rate of interest payable is much cheaper as compared to spending on credit cards.

How to go about it?

The process is similar to taking any other loan. You can offer your bank a host of collaterals, such as your house, shares, bonds, insurance policies, fixed deposits and obtain such overdraft facility. But each one of these has their own upsides and downside.

For example, taking an overdraft against property though allows you a larger line of credit as compared to a fixed deposit in absolute terms, property evaluation will take some time. However, the bank will be much quicker while sanctioning overdraft against fixed deposits.

“Banks are more comfortable offering an overdraft against fixed deposits and traditional life insurance policies. Typically, traditional life insurance policies do not offer good returns. Taking an overdraft against them is a better way to putting them to productive use, he adds.

Banks consider surrender value of life insurance policies while offering overdraft. Rajiv Raj says there are banks who selectively offer temporary overdraft facilities against salary of an individual. For example, if you have a salary of Rs 1 lakh a month, there is a credit line of Rs 50,000 available to you, the salary credited is adjusted against the credit outstanding at the end of the month.

You have to also factor in the ‘haircut’ – the margin of safety – the bank will take. For example, the bank will be comfortable in approving limit up to 50% of the value of the property but in case of a fixed deposit, may offer up to 70% of the fixed deposit amount.

Depending upon the limit you need, you should choose the collateral. Along with the collateral, banks charge a small one time fee — 0.5 to 1%, subject to a cap of, say, Rs 25,000. This is especially true when you are offering property as collateral as the bank has to conduct due diligence on the title and value of the property. Overdraft limits are approved for a year, and the bank typically reviews them each year.

Should you go for it?

Financial experts say, overdraft facility is meant for disciplined individuals. This is because many people tend to misuse the funds. “It is a credit line available with you, and if you use it to fund speculative activities such as short-term trading in stocks, commodities or currencies, it may backfire.

If you lose in such speculative adventures, you have to pay for it in addition to the interest accrued on the overdraft availed. And if you fail to pay on time, the bank may liquidate the asset.

Traps of overdraft Accounts

An overdraft account is a type of bank account that allows you to withdraw more money than what is available in your account, essentially borrowing from the bank. While overdraft facilities can be useful in emergencies or for managing cash flow, there are several potential traps that can lead to financial difficulties or unexpected costs. Here are some common traps associated with overdraft accounts:

1. High Interest Rates:

Trap: Overdrafts often come with high interest rates on the amount you borrow. The interest can be much higher than standard loan rates, leading to significant debt accumulation if not managed properly.
Solution: Always pay off the overdraft as quickly as possible to avoid high-interest charges. Check for accounts with lower overdraft interest rates or consider alternative financing options if needed.

2. Overdraft Fees:

Trap: Banks may charge a flat fee every time you go into overdraft, regardless of the amount you borrow or the duration. These fees can add up quickly, especially if you use the overdraft frequently.
Solution: Use overdraft facilities only when absolutely necessary. Try to keep track of your account balance to avoid unnecessary overdrafts and fees. If possible, opt for accounts with lower or no overdraft fees.

3. Continuous Overdraft Fees:

Trap: Some banks charge a daily or monthly fee for maintaining an overdraft, which can continue until the overdraft is cleared. If you have a large overdraft, this can become a long-term financial burden.
Solution: Aim to clear the overdraft as soon as possible to avoid ongoing charges. Set up alerts to notify you when your balance is running low.

4. Penalties for Exceeding the Overdraft Limit:

Trap: If you exceed your overdraft limit, the bank may charge you an exceedance fee or penalty, which can be quite expensive.
Solution: Stay within your approved overdraft limit and avoid exceeding it. Some banks may allow you to link your overdraft to a savings account for protection against exceeding the limit.

5. Automatic Overdraft Protection Charges:

Trap: Some banks offer automatic overdraft protection by linking a savings or credit account to your overdraft. While this can prevent your payments from being declined, the bank may charge you for this service, or the linked account may have its own fees.
Solution: Review the terms of automatic overdraft protection and consider opting out if the fees outweigh the benefits. Alternatively, keep a buffer in your primary account to avoid using the overdraft protection.

6. Short-Term Borrowing Trap:

Trap: Overdrafts are often used for short-term borrowing, which can lead to a cycle of relying on credit to cover day-to-day expenses. If you don’t manage the overdraft well, you may find yourself caught in a continuous cycle of debt.
Solution: Only use overdrafts for genuine emergencies. Try to budget your finances better and look for ways to reduce your reliance on overdrafts, such as building up an emergency fund or seeking alternative sources of credit.

7. Low Repayment Priority:

Trap: In some cases, overdraft debt may not be prioritized in your overall repayment plan, meaning you could end up paying other debts first and letting your overdraft accrue interest and fees.
Solution: Ensure that you treat your overdraft as a high-priority debt, especially since it can have high interest rates and fees. Pay it off promptly to avoid escalating costs.

8. Unclear Terms and Conditions:

Trap: Some overdraft agreements may not clearly explain the full cost of using the overdraft, including hidden fees, interest rate increases, or conditions for repayment.
Solution: Always read the terms and conditions of your overdraft facility carefully. Ask your bank for clarification if you don’t understand any fees or charges, and consider comparing different overdraft options from various banks to find the best deal.

9. Overdraft Limit Reduction or Cancellation:

Trap: Banks can reduce or cancel your overdraft facility at any time, especially if you have a poor repayment history or if the bank decides to alter its terms. This could leave you suddenly unable to access credit when you need it most.
Solution: Maintain a good relationship with your bank by managing your account responsibly. Keep your overdraft usage low, and avoid consistently maxing out the limit.

10. Impact on Credit Score:

Trap: If you frequently use your overdraft or fail to repay it on time, it can negatively affect your credit score. This can make it harder to get approved for loans or credit in the future.
Solution: Avoid using your overdraft facility regularly. Ensure that you pay it off quickly and on time to maintain a positive credit history.

11. Automatic Loan Conversion:

Trap: Some banks convert your overdraft balance into a personal loan if you haven’t cleared the overdraft within a certain period. The interest rates on personal loans can be different from those on overdrafts, and this could increase your debt burden.
Solution: Pay attention to any conversion clauses in your overdraft agreement. Try to repay the overdraft within the given time frame to avoid automatic loan conversions.

12. Hidden Terms for Renewal:

Trap: When your overdraft facility is up for renewal, some banks might change the terms or fees without clearly informing you. This could lead to unexpected costs if you continue using the overdraft.
Solution: Regularly check the terms and conditions of your overdraft facility, especially at renewal time. Stay in touch with your bank to ensure you’re aware of any changes.

Conclusion:

Overdraft accounts can be a helpful financial tool for managing short-term cash flow issues, but they come with significant risks and traps if not used responsibly. To avoid falling into debt, it’s crucial to be aware of the fees, interest rates, and terms associated with your overdraft. Always try to keep your balance in check, avoid using the overdraft for non-emergencies, and make it a priority to repay any borrowed amount promptly. By staying informed and proactive, you can avoid the common traps and use your overdraft facility in a way that benefits your finances.

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Disclaimer: The information provided here has been compiled from various sources to the best of our knowledge. While every effort has been made to ensure the accuracy of the details, there may be occasional errors or omissions. If you find any discrepancies or incorrect information, kindly inform us so we can make the necessary corrections. Thank you for your understanding and cooperation.