At times, businesses find themselves short of cash. Overdrafts help them cover their expenses despite their low Bank balances. An Overdraft is a popular credit facility among current account users. Usually there is a cost to use arranged overdrafts. This would be referred to as interest charges.

Statistics show about 1 in 5  UK adults said they use their bank overdraft every month. This happens because people don’t always know the advantages and disadvantages of overdraft facilities. Make sure you know if a bank overdraft is right for you.

Overdrafts explained: Meaning and working mechanism

How does an overdraft work? Overdrafts let current account users to withdraw money from their bank accounts despite having a low balance. Banks allow users to withdraw money up to a pre-decided limit. This might be called your overdraft amount. The overdraft limit is decided on the basis of the creditworthiness of the borrower. It also considers their income and affordability. Banks charge a fixed percentage of interest on the amount you have overdrawn.

Sometimes a bank will offer interest free overdrafts. An interest free overdraft allows you to borrow a little bit without paying any interest. These can be cheaper as there are no interest payments.

For example, imagine that you have £1000 in your current account and your overdraft limit is £500. You can make a payment of up to £1500 from your bank account. You will pay a fixed per cent of interest on the overdrawn amount of £500. If you need to spend more than £1500 you might need to use an unarranged overdraft. This can help you get more money, but it can also lead to more debt.

Let’s understand the advantages and disadvantages of bank overdrafts.

Advantages of using overdrafts

An overdraft facility can be extremely useful due to its convenience and flexibility. Here’s a glimpse into the major advantages of using overdrafts for your expenses.

1. Easy application process

The process of applying for an overdraft is pretty straightforward. Current account users have to submit an overdraft application to their banks. The bank decides the overdraft limit after reviewing the existing debts. The limit also depends on the credit history. It’s influenced by your account balance and other financial parameters. Sometimes a bank will even give you an interest free buffer.

Read this blog post to find out if an overdraft affects your credit score.

2. Flexibility

This is a crucial point to consider. An overdraft facility is one of the most flexible credit options. The facility remains available to you. It can be used whenever it is needed, unlike a Loan or credit card. Overdrafts have a flexible repayment term.

3. No charges for early repayment

Most credit options have a fixed repayment schedule. If you wish to pay a loan ahead of schedule, you may have to pay prepayment charges. As overdraft has no repayment deadlines, banks do not charge any fees for early repayment. You can pay it back whenever you have the funds.

Disadvantages of using overdrafts

Each line of credit has its own pros and cons. Even though an overdraft can be beneficial, there are certain drawbacks to it that one should keep in mind.

1. Low borrowing limits

An overdraft facility is a useful way of borrowing money. But it cannot replace a regular business loan. The borrowing limits of an overdraft facility are significantly lower than loans. An overdraft would be able to cover your operational expenses. However, if you need a huge amount of funds, say to get new machinery for your business. During such times, bank overdrafts cannot be of much help.

2. High interest rates

Bank overdraft facilities are convenient, but they don’t come without a cost. Banks charge high-interest rates on overdrawn amounts. In fact, in 2020 the Financial Conduct Authority had to intervene. It asked the banks to explain their high overdraft rates. Banks were charging interest rates as high as 40% on overdrafts at the time. Currently, the interest rate on an overdraft can range from 19% to 40%.

If you want to estimate your overdraft cost, you can use an overdraft calculator.

3. Possibility of reduction of the limit

Your overdraft credit limit is controlled by your bank. The bank can reduce the limit according to the circumstances. Such as if you have too low of a current account balance.

In fact, banks can also withdraw your overdraft facility permanently if required. This is a remote possibility. One should consider this while assessing the overdraft business advantages and disadvantages. Banks generally cancel overdraft facilities if the user has not paid back their overdrawn balance.

4. The risk of being constantly overdrawn

Users can develop the habit of using their bank overdraft limit constantly without ever paying it back. The interest cost keeps piling up, and the liabilities keep increasing. This could be called the overdraft affect.

According to consumer credit insights revealed by the FCA, consumers often do not see overdrafts as debt. They quickly become habitual to using them. The research also showed that overdraft users do not actively repay their overdraft. Most repayments are just funds coming into their bank accounts.

Are you struggling with your overdraft debt? Read this guide on how to get out of debt fast in 2023.

5. Unauthorised Overdrafts

When you apply to a bank for an overdraft facility, you get an authorised overdraft. Unauthorised overdrafts are unplanned or unarranged overdrafts. Occasionally, users spend more than what they have in their business bank account without realising it. This could be because an unexpected expense paid via direct debits leave your account.

This is called an unauthorised overdraft as there is no pre-existing overdraft arrangement with the bank. You would be charged an interest on the overdrawn amount by the bank. Banks are no longer allowed to charge more for an unauthorised overdraft. This should cost you the same as the arranged overdraft. If you’re the account holder and you use this, it can affect your credit rating.

If you don’t have a bank overdraft, ensure that you have a sufficient balance. Otherwise, you might find a payment is rejected.

Are there alternatives for overdrafts?

Have you evaluated the advantages and disadvantages of an overdraft? You may conclude that getting an overdraft isn’t right for you. There are plenty of other credit options to consider. Especially if you’re looking for short-term financing.

• Short-term loan: If you are in need of money for the short run, you can consider taking short-term loans. These loans are to be repaid in less than a year. Check out the advantages and disadvantages of short term loans here. Applying for these loans counts as a separate loan application. You can usually apply for these with short notice.
• Credit card: You can use a credit card instead of an overdraft facility to cover operational expenses. Some deals can offer you a low interest rate
• Line of credit: Under a line of credit, you can borrow money up to your pre-decided credit limit. The money gets deposited in your bank account, and you can use it like you would use your own money. It is very similar to an overdraft facility.

Final thoughts

Overdrafts can be useful for businesses with short-term financial needs. It is a convenient and flexible credit option, especially during emergencies. However, no line of credit is perfect. Even an overdraft facility has certain drawbacks and risks. You must consider it before choosing it for your business. It can be expensive due to higher interest rates.

Frequently asked questions

Disclaimer: The information given above is provided for reference only. This is not financial advice.

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