What Is an Overdraft Loan and How Does It Work

From piled-up groceries and a sudden car breakdown to medical emergencies, unexpected expenses arise and your savings account can't always keep up.

This is where an overdraft loan or an OD loan can help. But what exactly is an OD loan? 

Let us understand the overdraft loan meaning. It is a financial term used for the facility that allows you to withdraw more money from your bank account than what is currently available. With an overdraft, you can continue making transactions even if your account balance is zero or negative. 
This flexibility comes with interest charges and potential fees, so understanding how it works and its implications is also crucial. 

In this blog, we’ll delve into the overdraft loan basics. We’ll cover features, benefits, drawbacks, and different types of overdraft facilities to help you decide if it’s the right option for your financial needs.

Features of an Overdraft Facility

As seen earlier, an overdraft is a tool that can assist you with short-term cash management. To gain an in-depth understanding of what an overdraft loan is, you’ll also have to know its most important features such as:

• Pre-Approved Limit: The lending institution sets a maximum limit based on the account holder’s creditworthiness, allowing borrowing beyond the account balance.
• Flexible Access: Borrowers can withdraw funds as needed, up to the approved limit, without requiring a formal loan application each time.
• No Fixed Repayment Schedule: There are no mandatory monthly payments, offering flexibility in how and when you repay the borrowed amount. However, it's important to manage the overdraft balance responsibly to avoid accumulating excessive interest and fees.

Benefits and Drawbacks of Overdrafts

To make an informed decision on whether this facility is the right option for you, it is important to understand OD loans' pros and cons. Below is the rundown of both:

Benefits:

• Avoid Late Payment Fees: An overdraft helps cover expenses even when your account balance is insufficient, avoiding late payment penalties.
• Less Documentation: Overdrafts often require less paperwork compared to long-term loans, making them more accessible.
• Flexibility: You can access funds anytime and for any duration, even if just for a day or two.
• Interest on the Overdraft Loan Usage: Instead of the entire approved limit, interest is charged only on the amount you have withdrawn.

Drawbacks:

• Higher Interest Rates: Overdrafts typically have higher interest rates compared to other loan types.
• Changing Limits: Lenders may adjust the overdraft limit or require repayment sooner than expected, affecting your financial planning.
• Short-term Nature: Overdrafts are designed for short-term use, so the loan duration is often limited.
• An Unhealthy Cycle of Debt: If overdrafts are not managed carefully, there’s a high risk of debt and interest accumulation.

Different Types of Overdrafts

Overdraft facilities offer both secured and unsecured options. Here’s a brief explanation of OD loan types:

1. Secured Overdraft:

• Against Property: Borrowers can use their property as collateral to secure a higher overdraft limit. The lender evaluates the property's value to determine the credit limit, making this option suitable for those needing substantial funds.
• Against Fixed Deposits: Customers can access funds up to a certain percentage of their fixed deposit amount without breaking the deposit. This option provides quick cash while the fixed deposit continues to earn interest.
• Against Insurance Policies: The surrender value of a life insurance policy can serve as collateral for an overdraft. This allows you to borrow based on the policy's value, offering a flexible option for those with insurance assets.
• Against Stocks and Mutual Funds: Investments in stocks or mutual funds can be pledged as security. The overdraft limit is based on the market value of these assets, making it a viable option for investors.

2. Unsecured Overdraft:

• Against Salary: Salaried individuals can obtain an overdraft based on their monthly income, typically up to a multiple of their salary. No collateral is required, making it a straightforward option for salaried individuals who need quick funds.
• Pre-Approved Overdrafts: Some lenders offer unsecured overdrafts without requiring collateral. These are usually based on the customer’s banking history and creditworthiness, providing rapid access to funds when needed.

The Overdraft Limit: How Much Can You Overdraw?

A major consideration in the entire concept of an overdraft loan is your overdraft limit. It is the maximum amount a lending institution allows you to withdraw beyond your existing account balance.

Several factors are in play when lenders determine the overdraft limit. Typically it includes your income, credit history, and relationship with the lending institution.

It can range from INR 50,000 to as high as INR 5 crores, depending on your financial standing, repayment capacity, and lender policies. It's important to note that some lenders may also levy additional charges such as overdraft fees or annual fees.

What Is an Overdraft Loan Account?

Let us take a closer look at the explanation of an overdraft loan account. An OD loan account meaning is a facility offered by financial institutions where you can avail of funds even when the balance falls to zero. In this situation, you’re technically a borrower, and lending institutions are extending credit or a loan to you. 

While the facility does offer you a financial cushion against any unmet expenditures and emergencies, there are certain charges that you will incur for the facility. 

If not managed well, interest on the borrowed amount can quickly add up and you may have to pay penalties. Therefore, take some time to understand the fees and repayment details before availing the facility. This way, you can benefit from this financial tool and reduce any possible downsides.

How Does An Overdraft Facility Work?

To understand the meaning of an overdraft loan even better, let’s dig a little deeper into how the facility works in and out. Below are the overdraft loan details that can help you manage your finances wisely to avoid excessive fees and debt:

• Credit Limit: When you’re approved for an overdraft, the lender sets a maximum limit based on your creditworthiness and banking history. For instance, if your limit is INR 30,000, you can withdraw up to that amount even if your balance is zero.
• Interest Charges: You’re charged interest only on the amount you overdraw, not the total limit. If you use INR 10,000 of your INR 30,000 limit, interest is charged on the INR 10,000. This interest is usually calculated daily and billed monthly.
• Repayment Flexibility: Unlike traditional loans, there are no fixed monthly payments. You can repay the overdraft loan usage at your convenience, making it flexible. For example, if you overdraw INR 5,000 today, you can repay it when you have funds available.
• Fees and Penalties: While overdrafts offer flexibility, they come with fees, especially if used beyond the agreed limit. Unauthorised overdrafts often incur higher charges.

Conclusion

In finance, while overdraft facilities can assist with short-term cash flow issues, they may lead to unmanageable debt if not used judiciously. Therefore, it’s crucial to evaluate your financial needs and consider various options. Personal loans, with their structured repayment plans and lower interest rates, can provide a more sustainable solution for those seeking to manage their finances effectively.

While SMFG India Credit doesn’t offer any overdraft facility, you can explore our personal loan solutions that let you apply for amounts as high as INR 30 lakhs*. Interest rates start at only 13%* per annum and loan tenures go up to 5 years* to manage repayments without undue financial strain. Check your eligibility and apply online from the comfort of your home.