Overdraft

An overdraft is a credit facility attached to a current or transaction account that allows the account holder to withdraw more money than the account contains, up to an agreed limit. The account balance goes negative, and interest is charged only on the amount actually drawn, for the number of days it is drawn.

An overdraft is revolving and has no fixed repayment schedule. Money paid into the account automatically reduces the drawn balance; further withdrawals draw it back up. The facility remains available as long as the limit is not exceeded and the lender does not withdraw it.

It is the standard instrument for bridging short-term timing mismatches between money going out and money coming in — payroll before receivables land, stock purchases before sales convert to cash.

Arranged vs. unarranged overdraft

Arranged (authorised) overdraft. A limit agreed in advance between the account holder and the lender. Pricing is disclosed, the limit is known, and use within it is contractually permitted.

Unarranged (unauthorised) overdraft. The balance goes below zero — or beyond the arranged limit — without prior agreement. The lender may honour the payment or return it. Either way, unarranged use has historically attracted substantially higher charges than arranged borrowing, and it is the source of most consumer complaints about overdrafts. Several regulators have responded by capping or restructuring unarranged fees and mandating balance alerts before charges are triggered.

How overdraft interest is calculated

Interest accrues daily on the outstanding drawn balance, not on the limit. The facility costs nothing while unused.

Daily interest = drawn balance × annual rate × (1 ÷ day count basis)

Example. A business holds a $10,000 overdraft limit at 18% per annum on an Actual/365 basis. It draws $4,000 for 12 days:

Interest = 4,000 × 0.18 × (12 ÷ 365) = $23.67

The remaining $6,000 of limit costs nothing in interest. This is what distinguishes an overdraft from a term loan: on a $10,000 term loan the borrower pays interest on the full $10,000 from day one, whether or not it is needed.

The day count basis matters. Actual/365 and 30/360 produce different figures for the same rate and period, and the applicable basis should be stated in the facility letter.

What an overdraft costs

Interest is rarely the only charge:

• Interest on the drawn balance — usually variable, linked to a reference or base rate plus a margin
• Arrangement or facility fee — a one-off percentage of the limit when the facility is granted
• Annual renewal or review fee — charged on each review, again typically a percentage of the limit
• Non-utilisation fee — on larger commercial facilities, a small charge on the undrawn portion
• Unarranged overdraft charges — higher interest, daily fees, or both
• Returned item fees — when the lender declines a payment that would breach the limit

Because facility and renewal fees are charged on the limit rather than on usage, an oversized overdraft that is rarely drawn still costs money. Right-sizing the limit is a real decision, not a free option.

Overdraft vs. other short-term credit

• Overdraft - Structure: Attached to a transaction account

  • Interest charged on: Drawn balance, calculated daily
  • Repayment: No fixed schedule; account deposits reduce the balance
  • Typical tenor: Rolling, reviewed annually
  • Best suited to: Short, unpredictable cash gaps
  • Availability: Repayable on demand in most jurisdictions

• Term loan - Structure: Fixed principal, fixed schedule

  • Interest charged on: Full outstanding principal
  • Repayment: Fixed regular instalments
  • Typical tenor: Months to years
  • Best suited to: Asset purchases and known funding amounts
  • Availability: Contractually committed

• Revolving credit line - Structure: Standalone revolving facility

  • Interest charged on: Drawn balance
  • Repayment: Minimum monthly payments or defined drawdown terms
  • Typical tenor: Rolling committed period
  • Best suited to: Larger or ongoing working capital needs
  • Availability: Often committed for an agreed period

• Credit card - Structure: Revolving, card-based facility

  • Interest charged on: Statement balance remaining after the grace period
  • Repayment: Minimum monthly payment
  • Typical tenor: Rolling
  • Best suited to: Day-to-day purchases and short transaction float
  • Availability: Withdrawable by issuer

How lenders size a business overdraft

An overdraft is meant to fund the cash conversion cycle — the gap between paying suppliers and collecting from customers.

Cash conversion cycle = days inventory + days receivable − days payable

A distributor holding 45 days of stock, collecting in 40 days and paying suppliers in 30 days has a 55-day cycle. With annual operating cash outflows of $1.2 million:

Daily outflow      = 1,200,000 ÷ 365 = $3,288
Working capital gap = 3,288 × 55 ≈ $181,000

That figure anchors the limit. Lenders also apply cruder rules of thumb — commonly a percentage of monthly or annual turnover — and adjust for seasonality, customer concentration and the quality of the receivables book.

Facilities are usually reviewed annually, and renewal depends on account conduct: whether the account swings back into credit during the period, whether the limit was breached, and whether turnover through the account matches the declared trading level.

The hardcore overdraft problem

An overdraft is designed to fluctuate. If it swings between zero and the limit across a month, it is doing its job.

A hardcore overdraft is one that never returns to credit — the drawn balance has a permanent floor that never clears. That floor is not a timing gap; it is long-term funding that has been financed with a demand facility. It signals one of three things: the business is undercapitalised, it has funded fixed assets from working capital, or it is loss-making and the overdraft is absorbing the losses.

Lenders watch for this specifically, because it converts a short-term, on-demand exposure into de facto term debt without term-debt underwriting. The usual remedy is to term out the hardcore portion into an amortising loan with a defined repayment schedule, leaving a smaller overdraft for genuine fluctuation.

Risks to be aware of

• Repayable on demand. In most jurisdictions an overdraft is technically repayable on demand and the limit can be reduced or withdrawn, often with little notice. It is the least reliable form of committed funding — and lenders tend to reduce limits precisely when conditions deteriorate.
• Cost of permanent use. Overdraft rates are typically higher than term loan rates. A balance that never clears is expensive term borrowing.
• Review risk. Annual renewal is not automatic. A poor trading year can mean a reduced limit at the moment the business most needs it.
• Unarranged charges. Breaching the limit is significantly more expensive than borrowing within it.
• Dependency masking. Because there is no repayment schedule to fail, an overdraft can conceal deteriorating cash generation for a long time — often until the limit is reached.
• Security and guarantees. Business overdrafts are frequently secured by a debenture, a charge over receivables, or a personal guarantee from the owner. The facility is small; the recourse may not be.