What is a business overdraft (OD)?
A business overdraft is a phrase you may have heard before, but what precisely is it? It is essentially a credit limit tied to a business bank account or debit card that allows businesses to withdraw funds (up to an approved limit) beyond what is actually in the bank account.
Businesses must only pay interest on the amount overdrawn, making it a useful cash flow solution in several situations. A business overdraft, for example, could be used for:
- Employee compensation
- Stock acquisition
- Invoice settlement
- Taking care of other expenses
So, now that you understand what a business overdraft is, you could be wondering what its benefits and drawbacks are and whether any other funding options could be a better fit for your company. Continue reading for a breakdown.
How does a business overdraft work (with example)?
A business overdraft allows you to continue accessing funds even if your current account’s balance falls below zero.
Of course, you must repay the funds. You’ll also be required to pay interest on the sum of credit borrowed, just like with a business loan or business credit card. When you pay back the outstanding amount, your account balance returns to zero, which means you will no longer have to pay interest.
The overdraft will have a maximum limit by your overdraft provider, which is usually a bank. This limit can range from tens of thousands to millions of rupees and is determined by several factors, including your company’s revenue and credit history.
If your cash flow situation changes, you may be able to raise your overdraft limit. The bank will do so only if they genuinely think the company will be able to repay the extra funds borrowed.
If the bank is concerned about your ability to repay the overdraft, or if you request a big amount, the business overdraft may need to be a ‘secured’ overdraft.
Assume you own a small business with an account balance of Rs 80,000/-. You have to urgently make a payment of Rs 100,000/- to a raw material supplier. You know that money is on its way to you from your consumers. However, you cannot delay this particular payment.
Taking out a business loan makes no sense in this situation due to the amount of paperwork required. And the time it will take the financial institution to process the loan. Overdrawing instead makes sense.
Once the business overdraft facility is activated, Rs 80,000/- will get debited from your business’s bank account, and the remaining Rs 20,000/- will be paid to the supplier from the overdrawn amount, subject to your business’s permissible limits.
This payment can be made in any way you want, including by check, online transfer, or debit card. Once approved, it is your money, which you can access whenever and however you want to fulfil your short-term needs.
As soon as the overdraft loan of Rs 20,000/- is used, you will have to pay interest. You will then be required to pay back the borrowed money with interest to your bank within the specified time.
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Pros of availing overdraft for businesses
1. Safety net
One of the main pros of a business overdraft is you pay interest on the amount you overdraw. So it serves as a low-cost (based on fees) safety net you don’t even have to use.
2. Flexible term limits
In general, you’ll be able to discuss with your lender the length of time you’d like the business overdraft to be accessible, and you may even be able to renew it. You’ll even be capable of closing it at any time, but you’ll need to pay off any remaining balance or fees first.
3. Cash flow
When you don’t have sufficient money, a business overdraft can help you fund your business needs, especially if they’re unexpected.
4. Security options
Lenders typically offer both safe and secure and unsecured business overdrafts. The advantage of a secured overdraft is that you will presumably pay a lower interest rate in return for providing property or another asset as collateral.
An unsecured overdraft will charge you a higher interest rate. However, you will not be required to put up any collateral.
Cons of availing overdraft for businesses
1. Interest rates
While you will not have to pay interest on the balance of your overdraft that you do not use, you will have to pay interest (generally a daily rate) on the funds you do use.
It’s also important to note that business overdraft interest rates are substantially greater than business loan interest rates, so both may be worth considering as business funding options.
In addition to an interest rate, you may have to pay business overdraft fees – even if you don’t use it! These may include application fees, annual fees (usually charged as a cash amount or a percentage of the total limit), and late payment fees.
3. Ease of termination
While you can cancel your business overdraft whenever you like, the same is true for your bank. The bank can call off the overdraft at any time.
Difference between a secured and an unsecured business overdraft
A secured business overdraft requires a company asset (for example, a commercial property owned by you) as security, whereas an unsecured business overdraft does not.
If you have a secured overdraft but cannot repay it within the specified time limit, the bank may sell the asset to recoup the money you owe. In contrast, although an unsecured overdraft does not require collateral, the interest rate is more likely to be higher.
How is the interest rate calculated for an overdraft?
You can calculate the overdraft interest in a variety of ways. The interest rate can be fixed or variable. Overdraft interest rate calculators available online can provide a quick calculation. Calculating the interest on your own, on the other hand, is also simple. All you have to do is use the formula below:
A/N multiplied by R/P
Where A represents the amount overdrawn, N represents the number of days in a billing period, R represents the annual interest rate, and P represents the number of periods per year.
Fees involved in business account overdraft
As previously stated, banks charge interest on the amount of credit extended on a business overdraft. These rates are generally higher than those charged on commercial loans. However, interest charges are not the only way banks make money.
The following are a few extra business overdraft fees banks charge that you should consider before taking one out.
1. The application fee
It is the one to keep an eye out for. Most banks do not charge this. So if yours does, you should question it.
2. Accountancy fees
Your bank will charge you an ongoing fee for handling the overdraft.
3. Fee for arrangement
It is the fee that you must pay the bank up front for setting up the business overdraft facility for you.
4. Fee for unplanned overdraft/over-limit
You will have to pay the penalty for withdrawing money over your overdraft credit limit. You will also likely have to pay a higher interest rate on the money you withdraw over the set overdraft limit.
5. Fee for renewal
A renewal fee is a one-time fee assessed each year. It could be a fixed fee or a percentage of your agreed-upon overdraft limit.
6. Fee for changing the overdraft limit
You will have to pay a fee for modifying your business overdraft limit.
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How to tackle business overdraft costs
There are no ways to avoid the charges associated with business overdrafts. However, there are some things you can do to minimise them.
1. Maintain vigilance over your account.
It may seem obvious, but keeping track of your balance and preparing for the future (as much as possible) can help you decrease the amount you borrow and the charges you pay.
2. Speak with your bank.
Set up a meeting or contact your bank if you’re having trouble managing your business overdraft. Check to see if they can waive any fees or lower the interest rate. You would not get it until you ask for it.
3. Prioritise your higher-interest debts first.
If you owe other debts, list them all, including interest and fees. If your business overdraft is the most costly, check if you can make minimum payments on other debts to direct incoming cash toward your overdraft.
Alternatives of business overdraft
While a business overdraft may be an excellent solution for certain types of business funding requirements, there are several other options that you can consider depending on your company’s specific funding requirements.
1. Business loans
A business loan is a commonly used option for companies that need financial support over a longer duration, either for cash flow or to finance large purchases.
Business loans, like regular loans, are taken out for a set period, with debtors obligated to regularly pay interest payments (at either a variable or fixed rate) on the loan balance. Business loans, like business overdrafts, can be secured or unsecured, and they usually come with several fees.
However, because interest rates on business loans are usually lower compared to business overdrafts, they may be a more cost-effective alternative for companies with predictable expenses that don’t necessitate the wiggle room of a business overdraft.
2. Business credit cards
Businesses use credit cards to manage cash flow and stump up for small expenses. Business credit cards, like business overdrafts, are a line of credit with a predetermined limit, an interest rate, and several fees.
Unlike overdrafts, many credit cards allow businesses to earn rewards points for purchases, which you can redeem for travel or retail rewards.
Frequently asked questions (FAQs)
Is an overdraft a type of loan?
Yes, an overdraft is a short-term loan made available to account holders by financial institutions.
Is it possible for a small business owner to obtain an overdraft?
Yes, overdrafts are ideal for self-employed individuals and small business owners. It assists them in managing their cash flow and paying their stakeholders on time when debtors’ dues and creditors’ repayment dates differ.
Does having an overdraft affect your credit score?
Yes, overdrafts are ideal for self-employed individuals and small business owners. It assists them in managing cash flow and paying stakeholders on time when debtors’ dues and creditors’ repayment dates differ.
On a concluding note
Bank overdrafts are beneficial to small entrepreneurs and business owners. The bank will grant an overdraft either with or without a mortgage. Bank overdrafts are convenient, but they are more expensive than loans.
Overdraft is distinct from other types of credit. You can compare overdraft with a loan and cash credit to determine which is best for your company.