How Does an Overdraft Work? Is It An Effective Form of Finance?
Overdraft is a type of revolving credit extended to businesses and individuals to provide working capital. An overdraft allows business owners to withdraw funds (up to an agreed amount) from a chequing account, even when the balance of the account is zero. In other words, an overdraft allows a business to spend more money than it has in its account at a given time.
Overdrafts are frequently used by businesses to manage cash flow and cover unexpected expenses that arise. In general, overdraft users pay interest only on the money they are using, which can save borrowers money in contrast to a standard business loan.
Prior to applying for overdraft protection, business owners must consider the benefits and disadvantages of this financing option.
Benefits of an overdraft facility for business owners:
- Flexible credit options
- Ability to manage seasonal or irregular cash flow
- Pay interest only on the funds currently extended
- No fee on merchant summaries
- Prevents businesses from incurring bounced cheque fees
- Overdraft financing is easy to secure and provides instant financing when the business' funds are tight
Disadvantages of an overdraft facility for business owners:
- Higher interest rates than business loans
- Can conceal bigger cash flow and liquidity issues
- Overdrafts have a set limit, and businesses who spend beyond that limit can face hefty fines and even higher interest rates
- Overdrafts are frequently secured by business or personal assets. If the business is unable to bring the overdraft current through payments, the collateral can be seized
- The entire overdraft amount can be recalled by the bank at any time if the overdraft terms or conditions are broken
Is an overdraft an effective form of finance for my business?
Overdrafts are a good form of finance for business owners who experience occasional cash flow problems, such as businesses that operate on a seasonal basis. Overdrafts are not an effective form of finance for asset purchases; however, they are an ideal source of working capital for short-term needs. Overdrafts are also be used to provide capital between the time a business' bills are due and the time the business' customer accounts are paid.
If your business frequently must rely on overdraft to maintain liquidity, this may be a warning sign of a bigger cash flow problem that should be addressed promptly. Overdraft facilities are best used as a short-term financing solution to cover unexpected expenses.
Is security required for an overdraft?
Not always. Overdrafts can be unsecured, provided that the business meets the lender's credit and other criteria. However, an overdraft secured by property, business assets, or another form of collateral will generally have lower interest rates.
Do I automatically have an overdraft?
No. Businesses should not presume they have an overdraft facility and spend more than the balance in their account with first speaking with the bank. Overdrawing without an overdraft facility can result in steep fees and charges, and lenders often charge interest rates as high as 30% in unapproved overdrafts.
Does overdraft have limits?
Most lenders will set a maximum amount by which the account can be overdrawn, also known as an overdraft limit. Exceeding this limit can result in steep fines or fees and extremely high interest rates assessed on the amount charged over the limit.
Are penalties assessed for repayment?
No. Most overdraft facilities can be fully or partially repaid at any time without incurring a penalty or charge.
What kind of interest rates do overdraft facilities carry?
Overdraft facilities generally have variable interest rates; however, some lenders may be willing to negotiate a fixed interest rate on the overdraft facility.
How do I apply for overdraft protection?
Speak with a representative of the bank that holds your business chequing account for more information about overdraft facilities available to your business.
Overdraft facilities are an effective means of short-term financing for businesses that are in good financial health. Overdraft facilities are a flexible, quick means of obtaining working capital when cash flow is slow; however, overdrafts do carry risks. Because they carry fees for use of the facility and higher interest rates on the funds extended than traditional business loan products, overdraft facilities are not intended for long-term financing such as asset purchases or funding business investments. Business owners interested in applying for an overdraft facility should speak with a bank representative to discuss the pros and cons of overdraft for their business account.