Written byAn overdraft is a short-term credit facility attached to a transaction account that lets you spend past your available balance up to an agreed limit.
Also known as: bank overdraft, business overdraft, overdraft facility
Key points
- You pay interest only on the amount you are overdrawn, and only for the days you are overdrawn.
- It is built for smoothing cashflow gaps rather than long-term borrowing, which is where it gets expensive.
- An authorised overdraft has an agreed limit; going past it brings higher fees, dishonours and default interest.
- Business overdrafts carry larger limits and may need security, covenants or a personal guarantee.
- The facility is usually repayable on demand or reviewed periodically, so a bank can reduce or withdraw it.
How an overdraft works
The bank sets a limit and a rate, usually a margin above its reference rate. Within the limit, payments go through like normal banking, and interest is charged on the overdrawn balance, normally worked out daily and billed monthly. There is no scheduled principal repayment: money arriving in the account brings the balance back up, and you can draw on it again if the facility revolves.
Go past the limit, or overdraw an account with no facility at all, and the position is unauthorised. Banks charge more for that, may dishonour payments and can apply default interest. The order in which credits and debits are processed on a given day decides whether an item tips into the overdraft, which matters if you run close to zero.
Types of overdraft
A personal overdraft sits on an everyday transaction account, is often unsecured and comes with a modest limit. A business overdraft carries larger limits and is built around working capital needs, which is why lenders more often ask for security or financial covenants.
Security can be a property mortgage, business assets or director guarantees, and it usually pulls the margin down. Without it, the rate is higher and the limit tighter. Facilities also split between revolving, where you use and repay on an ongoing basis, and temporary, a short fixed-period arrangement for a seasonal shortfall.
Where an overdraft fits
An overdraft suits unpredictable, short gaps: supplier payments falling due before receivables land, or a quiet month in a seasonal trade. Because you only pay for what you use, it is cheap to hold and quick to draw on. The trade-off is that the bank can cut or cancel it for credit reasons or a breached covenant, which can bite at the worst moment.
If the balance never returns to credit, the borrowing is structural rather than seasonal, which is what a business loan or a line of credit is built for, while a credit card can suit purchases with an interest-free period. Low-balance alerts, transaction ordering, the review date and any commitment fee are worth checking at renewal.
Not to be confused with
- Line of credit
- a line of credit is a separate revolving facility rather than a limit attached to your transaction account
- Revolving credit
- revolving credit is the general category, and an overdraft is the transaction-account version of it
Frequently asked questions
How is interest charged on an overdraft?
Typically daily on the overdrawn balance and billed monthly, so you pay only for the amount used and the days you use it. There may also be an establishment or ongoing commitment fee for having the facility available, plus dishonour fees if a payment bounces.
Can the bank remove my overdraft?
Yes. Overdrafts are usually repayable on demand or reviewed periodically, so a bank can reduce or withdraw the facility for credit reasons or a breached covenant. It will normally notify you, though it can move quickly where it sees risk.
Will an overdraft affect my credit file?
The facility itself may be reported. Defaults, unauthorised overdrafts and cancellations can appear on your file and count against you in later lending decisions. Sitting close to the limit month after month also shapes how a lender reads your position.
Is an unauthorised overdraft illegal?
No, but it sits outside your agreed terms. Banks charge higher fees for it, can dishonour the payment and may apply default interest. If you know a shortfall is coming, ask about a temporary limit increase rather than going over.
Is overdraft interest tax deductible?
For a business, interest is generally deductible where the borrowing is used to earn assessable income. Private use is not. The detail depends on how the account is actually used, so check with your accountant or the ATO.
Related terms
Broader term: Working capital
Line of credit
A line of credit is a revolving credit facility with an approved limit that you can draw, repay and redraw, paying interest only on the drawn balance.
Read definitionWorking capital
Working capital is the difference between a business's current assets and current liabilities: the measure of whether it has enough liquid resources to meet obligations due within 12 months.
Read definitionBusiness loan
A business loan is finance for business operations, capital expenditure or growth, repaid with interest, either over an agreed term or as a revolving limit you draw and repay.
Read definitionCredit card
A credit card is a form of revolving credit that lets you borrow up to a pre-approved limit for purchases, cash advances or short-term finance.
Read definitionRevolving credit
Revolving credit is a form of credit that lets you draw, repay and redraw funds up to a pre-set limit, with minimum monthly repayments.
Read definitionInvoice discounting
Invoice discounting is a working capital facility where a lender advances most of an unpaid invoice's value and holds a reserve until your customer pays.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.