You need money, on and off, to bridge cashflow gaps for your business needs.
A loan may not be suitable for such a requirement. Why?
Firstly, you do not need money all the time. You need it infrequently. In that case, it may not make sense to bear the loan interest rate for 2 years when you need money for only 90 days during those 2 years. You can consider taking out a loan every time you are short on cash, but the entire process will become cumbersome. Additionally, if you want to foreclose the loan to save on interest costs, you may have to incur prepayment penalty if your loan is a fixed rate loan. Therefore, you need a different credit product to meet this requirement.
Enter the “Overdraft” facility. Overdraft facility is also a loan but differs from a regular loan in multiple aspects.
What Is an Overdraft Facility?
- An overdraft facility is a revolving credit facility, much like a credit card. You can withdraw funds from the overdraft facility as many times as you want provided your total outstanding does not exceed the sanctioned limit. You have an overdraft facility of Rs 5 lacs. You withdraw Rs 5 lacs and deposit Rs 3 lacs in the account a few days later. Your credit limit opens again to the tune of Rs 3 lacs, and you can withdraw again if you want. (In case of a term loan, you cannot make multiple withdrawals. You take a loan of Rs 5 lacs, and you withdraw Rs 5 lacs. That’s it. You cannot make any further withdrawals from this facility. Even if you prepay the loan, the limit does not become available again.)
- You pay interest only on the amount you have utilised. That is fair too. You have an OD facility of Rs 5 lacs, but you have drawn only Rs 1 lac. You pay interest only on the drawn amount, not on the entire sanctioned limit. While there is nothing special about this feature (all loans work like this), if you combine this feature with point (1), you can sense the flexibility an OD facility can offer for your business needs, where your fund needs may be irregular. You need money for a week. You withdraw from the OD account (no questions asked). You return the money to the OD account after a week. You will be charged interest for just one week.
While there is no restriction that you can avail an overdraft facility only for business needs, it helps to not extend the use for personal expenses. If the borrower is not responsible with credit, this can lead to serious problems later.
In any case, for personal use, a credit card bridges this gap for most people. A credit card also offers an interest-free credit period that an overdraft facility would never offer. But yes, if you are prudent with your finances and you do foresee such intermittent and short-term cashflow gaps even for personal usage, you can consider such a facility.
What are the costs associated with an Overdraft facility?
- Processing fee: usually 1-2% of the OD account.
- Interest cost: OD facility can be both secured and unsecured. Expectedly, the interest rate for an unsecured facility would be much higher than the secured one. An unsecured OD facility will cost you between 12-18% p.a. On the other hand, for an OD facility backed by a bank FD, you may just have to pay 1-2% more than the bank FD rate. Hence, if the FD is at 7% p.a., you may have to pay only 8-9% p.a. for the OD facility.
There may be certain ancillary charges too such as stamp duty, or valuation charges for the secured OD facility (against FD, property, or gold).
An overdraft needs to be renewed every year or at regular intervals. Hence, you must bear processing fee/renewal costs on regular intervals. If your usage is expected to be infrequent, you must weigh these costs against the benefit derived before opting for an OD facility.
Credit cards, personal loans, overdraft facility: These are all credit facilities. When you use these products, you owe your bank the money. What you have borrowed must be repaid. Credit also gives you the power of spending the money you have not earned yet. This prowess can harm you if you are not responsible. You may end up spending too much and gradually get into debt troubles. Hence, be responsible.