Overdraft facility: Meaning, interest rates & how OD loans work

Summary

An overdraft facility is a flexible borrowing option that lets you withdraw more than the available balance in your bank account, up to a pre-approved limit. Interest is charged only on the amount you use, making it useful for managing short-term cash-flow needs. Based on the involvement of collateral and the end user, overdraft loans can be classified into various types. Understanding the features of each type can help you make an informed borrowing decision.

An overdraft facility is a pre-approved revolving credit arrangement that allows you to withdraw money beyond your bank account balance up to a sanctioned limit.

Have you ever faced a situation where you needed money urgently but your bank balance was running low? It could be to pay a supplier, cover a medical emergency, or manage an unexpected business expense. In such cases, arranging a new loan may take time. This is where an overdraft facility can be useful.

But what is an overdraft, and how does it work? Simply put, an overdraft allows you to withdraw more money than what is available in your account, up to a pre-approved limit. In this guide, we explain the overdraft meaning, how an overdraft loan works, its interest rates, eligibility, benefits, and everything else you need to know before opting for one.

What is an overdraft facility?

An overdraft facility is a pre-approved borrowing facility offered by a bank or financial institution that allows you to withdraw more money than the balance available in your savings or current account, up to a sanctioned limit.

Unlike a regular loan, interest is charged only on the amount you actually use and not on the entire approved limit.

As you repay the borrowed amount, the credit becomes available again, allowing you to withdraw and repay funds multiple times during the approved tenure.

How does an overdraft loan work?

Now that you have understood what an overdraft loan is, let’s discuss how it actually works.

An overdraft loan is typically a revolving line of credit attached to your savings or current bank account.

The lender first approves an overdraft limit based on factors such as your income, repayment capacity, existing relationship with the bank, or the collateral offered, if applicable.

Once the limit is sanctioned, you can withdraw funds from it whenever required instead of taking the entire amount at once.

When you repay the borrowed amount, the limit is restored.

You can withdraw and repay repeatedly within the approved limit.

What are the types of overdraft facilities?

An overdraft facility can be classified in different ways depending on whether the collateral is involved or who is using the facility.

Based on collateral:

• Secured overdraft: If an overdraft loan is backed by collateral, it is known as a secured OD. The collateral can be a fixed deposit, property, shares, an insurance policy, or any other approved asset. This makes a secured OD a practical option if you’re already weighing a loan against property for business needs, since the same asset can often support either. The overdraft limit depends on the type and value of the collateral and the lender’s terms. Common collateral-backed overdraft facilities include:
• OD against Fixed Deposit: The lender provides an overdraft against the value of an existing fixed deposit. The sanctioned limit is generally set as a percentage of the FD value, which varies by lender and product.
• OD against Property: The lender allows you to borrow against the value of a property. The eligible limit depends on factors such as the property’s value, location, type, and the lender’s loan-to-value criteria.
• OD against Securities or Shares: An overdraft or credit facility may be offered against eligible shares, mutual funds, bonds, or other securities. The limit is generally a percentage of the market value of the pledged assets and can vary by security type and lender.
• Unsecured overdraft: If an OD is offered without any collateral, it is known as an unsecured OD. The lender approves the limit based on factors such as income, credit history, and repayment capacity.

Based on the user:

• Personal overdraft: This type of overdraft lending is designed for individual borrowers. They can use it to meet short-term personal expenses or tackle financial emergencies.
• Business overdraft: This type of OD is designed for businesses. They can use it to manage working capital needs or bridge temporary cash-flow gaps. If a business overdraft doesn’t quite fit, a business loan for working capital needs is worth comparing separately.

Another common form is a salary-backed overdraft, where the lender determines the available limit based on the borrower’s salary, income, and banking relationship. Unlike an OD against an FD or property, it does not necessarily involve pledging an asset as collateral.

Secured vs. unsecured overdraft

If shares, bonds, or mutual funds are the collateral in question, it helps to first understand how a loan against securities is valued and structured before you pledge them for an OD.

What are the OD interest rates?

OD interest rates vary from one lender to another and depend on factors such as the type of overdraft facility, the borrower’s credit profile, relationship with the lender, and whether the overdraft is secured or unsecured.

In general, secured overdrafts carry lower interest rates than unsecured ones because they are backed by collateral.

Another important feature of overdraft lending is that interest is charged only on the amount actually used, not on the entire sanctioned limit.

The interest is typically calculated on a daily outstanding balance and is usually debited or billed on a monthly basis.

For floating-rate overdrafts, the interest rate may be linked to a lending benchmark, such as an external benchmark or, where applicable, the lender’s MCLR. The applicable benchmark, spread, and reset frequency depend on the lender and the terms of the overdraft facility.

If you fail to pay interest or other dues on time, the lender may impose applicable penal charges in accordance with its policy and RBI regulations. The exact charges and treatment of overdue amounts depend on the terms of the overdraft facility.

What are the limitations of an overdraft facility?

An overdraft facility is convenient, but it isn’t without trade-offs. Once the overdraft meaning and its revolving nature are clear, weigh these limitations before leaning on one as your primary source of working capital:

• Higher interest rates than term loans: Because an OD trades fixed structure for flexibility, lenders typically price it above a comparable term loan, especially on the unsecured side.
• The bank can revise your limit: Your sanctioned limit isn’t fixed for life. The lender can reduce it, or withdraw it altogether, if your account conduct, income, or relationship with the bank changes.
• Annual renewal is usually required: Most OD facilities run in 12-month cycles and need periodic renewal, which means fresh paperwork and a fresh eligibility review each year.
• Risk of a debt trap if misused: Because funds are so easy to access, it’s tempting to treat an OD like extra income rather than short-term credit. Left unpaid, that balance, plus any penal interest, keeps compounding on the principal.

What are the fees and charges on an overdraft facility?

Besides interest, a loan on overdraft usually carries a few standard charges. Exact numbers vary by lender, but you can generally expect:

• Processing fee: Charged once, at the time your OD limit is sanctioned, usually as a percentage of the limit or a flat amount.
• Annual renewal fee: Charged each time the facility comes up for its yearly renewal, though some lenders waive this depending on the product.
• Non-utilization or non-maintenance charges: Some lenders charge a small fee if you sanction a large limit but use very little of it, since the bank has still set funds aside for you.
• Penal charges: Applied if you miss an interest payment or exceed your sanctioned limit, on top of the regular interest already due.

Features and Benefits of an Overdraft Facility

• Interest charged only on amount used: Interest is charged only on the amount you use, not on the entire OD limit.
• Flexible, revolving access: You can enjoy flexible, revolving access to funds, with the credit limit restored after repayment.
• Quick liquidity: An OD loan offers quick liquidity to meet temporary cash-flow shortages or unexpected expenses.
• No repeated applications: You won’t have to apply for a new term loan every time you need short-term funds.
• Multiple transactions: You can withdraw and repay funds multiple times during the approved tenure.
• Flexible product options: You can apply for a business or personal OD, depending on your requirements.

Also read – Overdrafts on home loans

Overdraft vs term loan: Key differences

Both OD and term loans allow you to borrow money. However, they are designed for different financial needs and entail different structures. An overdraft loan is better suited for short-term financial requirements, whereas a term loan is generally suitable for planned, long-term expenses. The table below compares the two lending options:

If you’re weighing a term loan’s fixed EMI against an OD’s flexibility, it helps to first know how loan EMIs are calculated before you decide.

Also read – Cash Credit vs Overdraft: What’s the Difference

What are the eligibility criteria, and how to apply for an overdraft facility?

The eligibility criteria for an overdraft facility may vary from one lender to another. They typically analyze factors such as the borrower’s age, credit score, monthly income, and employment stability. The value of the collateral also matters in the case of a secured loan.

Since your credit score is one of the first things a lender checks, it’s worth taking a moment to check your CIBIL score before you apply.

You can apply for an overdraft loan online with a bank or non-banking financial company in the following steps:

1. Visit the lender’s official website or mobile app.
2. Select the ‘Overdraft Facility’ or OD Loan option.
3. Fill out an online application form.
4. Upload your KYC documents along with the income and employment proof.
5. Upon successful verification, the lender sanctions an OD loan limit.

Conclusion

An overdraft facility can help you manage temporary cash-flow shortages without taking a separate loan every time. Since interest is charged only on the amount you use, it can be a practical financing option for both individuals and businesses. However, it is important to borrow responsibly, repay on time, and compare OD interest rates across lenders before making a decision. If you are exploring flexible business financing, you can consider Tata Capital’s business finance solutions.