You open a bank fixed deposit of Rs 5 lacs for 2 years at 7% p.a. After a couple of months, you need Rs 2 lacs to meet a planned expense. To meet the expense, you take out an overdraft facility against the FD of Rs 5 lacs. The interest rate on the overdraft facility is 1% more than the FD rate. Since the FD rate is 7% p.a., the overdraft interest rate is 8% p.a. Is this a good idea?
Many people just hate credit. For them, an OD against a bank FD is a bad idea. For others who are more open to credit, they may find such products both useful and flexible. Which side are you on?
Before we look at the merits and demerits, let us consider an OD against Fixed deposit product from SBI.
SBI Overdraft against Bank Fixed Deposit Facility
- Minimum amount: Rs 5,000
- Maximum amount: Rs 5 crores
- Available as both demand loan and overdraft product. We are more interested in the overdraft product in this post.
- Overdraft facility up to 90% of the FD amount. So, if you have a FD of Rs 5 lacs, your OD facility could be up to 4.5 lacs.
- No processing fee and prepayment charges
- SBI will mark a lien on your fixed deposit. You expect this. You cannot access/break your FD until the OD facility is live.
- Facility of up to 5 years
For more on this facility, refer to the product page and the FAQs.
What Are the Merits of Such an Overdraft Product?
Firstly, an Overdraft facility is a revolving facility just like a credit card. You can withdraw from the facility multiple times.
For instance, your OD facility is Rs 1.5 lacs. You withdraw Rs 30,000. Your drawing power goes down to Rs 1.2 lacs. You repay Rs 30,000 (along with interest). Your drawing power gets reinstated to Rs 1.5 lacs. And your next withdrawal can be up to Rs 1.5 lacs.
Contrast this with a demand loan product where you can withdraw just once or can’t cumulatively withdraw more than the sanctioned loan amount.
Secondly, you pay interest only on the utilized amount. In the above example, you pay interest only on Rs 30,000 (and not on Rs 1.5 lacs).
Thirdly, the interest rate is quite low. This is because it is a secured facility. And the security is a bank FD, which is the most liquid security for a bank.
Contrast this with the interest rate on a personal loan and a credit card. Yes, a credit card gives you an interest-free credit period, but you must pay back the amount in full before the next due date. If you don’t, you pay a very high interest from day 1 of purchase. No such issues with OD account. You pay the contracted rate until you repay the amount in full.
Unlike a personal loan, there are no prepayment charges either. You can withdraw today and pay in full after 5 days. No penalty.
Finally, you do not have to break your bank FD or sell investments to fund an expense. And this itself is cost-saving.
Let us consider an example. You opened Rs 5 lacs FD for 2 years. You get 7% p.a. You cannot break the FD partially. Even for a Rs 50,000 expense, you will have to break the full FD. If you break the FD after 3 months, you will earn the interest applicable to a 3-month FD. Let us say the FD interest rate for a 3-month FD was just 4%. You will earn only 4% (and not 7%) for the duration of the FD. If you were to sell your MF investments, you will have to pay capital gains tax. Yes, capital gains tax must eventually be paid but you pay tax at a lower rate on long term capital gains (compared to short term capital gains).
An Overdraft against FD Facility Can Offer You Immense Flexibility
Let us consider a few examples.
Example 1: You need Rs 50,000 just a few days before your salary credit. You wouldn’t have to worry if this money was required after a week. So, you have a cash flow mismatch of only a few days or weeks. You know that you will be able to pay back this amount within a week. But how do you manage this Rs 50,000 right now?
With a personal loan, you will have to spend time on application and even then, you may not get the money instantly. You must pay the processing fee. There is a higher interest rate. And you can’t close the loan after a week. Well, you can, but you will have to pay a prepayment penalty.
With an overdraft facility, you have instant access to money. No extra fee (processing fee, if any, is paid at the time of signing up for the facility). You pay interest only for a few days.
Example 2: You know you will be a bit short on cash for the next couple of months. You must purchase an item for Rs 50,000. You can use your credit card, but you know you won’t be able to pay the card bill in full.
You can convert your credit card expense into an EMI but there will be a processing fee and you will have to pay a much higher rate of interest (16-24% p.a.). There is a prepayment penalty too.
However, if you had access to an overdraft facility, you could swipe your credit card. Enjoy the interest-free credit period. Subsequently, pay the credit card bill from the OD account. No processing fee. Lower rate of interest. No prepayment charges.
What Are the Demerits?
- On the interest income on the bank fixed deposit, you will pay tax at your slab rate.
- Unless your overdraft facility is for a business purpose, you can’t consider your OD interest paid as an expense. Thus, the post-tax difference between FD interest and the OD interest is much wider than 1%.
- In the SBI Overdraft against FD facility, there is no processing fee. Other banks may have a processing fee. Since the overdraft facility must be renewed every year, there may be a renewal fee too. Such charges add to the cost of the facility.
I can’t really find flaws with the OD against Fixed deposit product unless the product has a high processing fee. Would prefer one with zero processing fee. You get great flexibility with your cash flows. However, you have a problem if you get too used to it. If your account is constantly overdrawn to the hilt (almost complete utilization of the facility), then you have taken it to the other extreme. If you have a very high utilization at all times, then there is no flexibility left. You can’t withdraw more. This becomes just another loan (although at a low cost and is revolving in nature).
Therefore, I would qualify my statement: An OD facility against FD is useful only to a responsible borrower.