Not all credit is bad. In this post, I will show how an overdraft facility can be useful in certain cases.
What Is an Overdraft Facility?
An overdraft facility is a revolving credit facility just like a credit card. You pay interest only on the drawn (utilized) amount. You can draw from the facility up to the OD limit (drawing power). As and when you pay partial (or full repayment), the drawing power is automatically released.
For instance, you have an OD facility with drawing power of Rs 2 lacs. You draw Rs 50,000 from the facility. The drawing power goes down to Rs 1.5 lacs. After a week, you deposit the amount (along with interest) in the OD account. The drawing power gets reset to Rs 2 lacs.
You can request your bank to sanction you an OD facility against your bank FDs and stocks/mutual funds. The OD facility need not be secured but you can expect the interest rate to be higher for unsecured OD accounts. There can be a one-time processing fee for OD account, ranging from 1% to 2% of the sanctioned limit. OD facility is for a year and needs to be renewed every year. The renewal fee can also be 1-2% of the credit limit.
Alternatives to Overdraft Facility
An overdraft facility provides you flexibility and potentially lower interest cost. This is better explained with the help of an example.
You use your credit card to purchase an item worth Rs 1 lac. You know you would struggle to repay the credit card bill in full before the due date in a few weeks. You foresee a few cashflow issues over the next few months. OR you expect your annual bonus in the next 2-3 months and you can close your loan with the bonus money.
You have a few options:
- You can select an EMI option during the purchase. For online purchases, those EMIs are cheaper at about 13-15% per annum OR
- You can make the payment in full and then ask the bank to convert the purchase amount to EMI. This is usually more expensive than the first option. At 24% p.a. or so.
- There is an option of No-cost EMIs, but I won’t consider this since this option is not always available.
- You can also revolve your credit card debt but that is an expensive choice.
Choice (2) is likely available for all kinds of purchases.
What are the issues with the 2nd choice? You must take out a loan for a certain tenure. You must pay the EMI for those number of months. 3 months, 6 months, 12 months, or 24 months, as the case may be. What if you have money before the loan matures? What if you want to close the loan earlier to avoid interest cost? If you close the loan before that, you must pay a prepayment penalty.
And therein lies the problem. A loan (personal loan or credit card debt converted into personal loan) imposes costs on early closure. There is no such restriction on credit card debt, but the debt is quite expensive.
How Would an Overdraft Facility Help?
An overdraft facility helps manage uncertainty better and will likely be cheaper than a personal loan, especially if it is a secured facility. Let’s say you spend Rs 1 lac on your credit card and then draw from your OD facility to square off the loan. The interest will be lower. More importantly, you can repay the loan whenever you want. You just have to keep paying interest every month. Not just that, you can enjoy the full interest-free credit period on credit card purchase. Just before the bill due date, you can draw from the OD facility. This will reduce the interest outgo.
Overdraft Facility against Existing Investments
Debt Mutual Funds
You have Rs 1 lac in debt mutual funds. You had put 90,000 and the amount has grown to Rs 1 lacs. If you sell the investment to fund your purchase, your short-term capital gain will be Rs 10,000. Capital gains tax of 3,000. This is the cost of funding purchase through your investments.
Let’s say, if you can hold this investment for 1 more year (so that it completes 3 years), the resulting gain gets taxed at 20% after indexation. Net tax impact may just be 10-15% of your capital gains. Therefore, by not selling the investment for another year, you save half the tax amount.
Now, instead of selling your debt funds, you take out money from the overdraft account and pay it back after a month. You pay only ~1,000 in interest. Had you sold your debt funds, you would have paid Rs 3,000 in taxes.
In this case, you have the money. Still, using an overdraft facility might help you save taxes.
You opened a bank FD of Rs 10 lacs a few years ago when the interest rates were high. You can break your bank FD and use the funds. However, you need only Rs 1 lac. If you break the entire FD, use 1 lac, and make another FD of 9 lacs, the new FD will be opened at a low interest rate (the prevailing interest rate). Additionally, there is a small penalty for breaking a bank FD prematurely.
Instead, you could leave the FD untouched, withdraw from your OD account and then deposit money in the OD account in a few weeks or months. In such a case, the OD interest paid may be much lower than the interest forgone by breaking the FD.
Should You Use OD Facility?
There is no one-size-fits-all solution. Let us not forget overdraft is a credit facility. You have a credit facility of Rs 5 lacs. You add an overdraft facility of Rs 2 lacs to your credit bucket. Now, if you are irresponsible with a credit limit of Rs 5 lacs, you can be irresponsible with a credit facility of Rs 7 lacs too. Therefore, the benefits of the overdraft rest on the premise that you are a responsible borrower. If this premise does not hold, an overdraft facility will only get into a deeper debt rut.
If you are a responsible borrower, you can use the overdraft facility to your advantage in a few cases. Consider the interest cost, the processing/renewal fee, the flexibility, and cost/tax savings before using an OD facility.