Bank Overdraft

Definition:
An overdraft is an extension of credit from a lending institution that is granted when an account reaches
zero. The overdraft allows the account holder to continue withdrawing money even when the account
has no funds in it or has insufficient funds to cover the amount of the withdrawal.

Basically, an overdraft means that the bank allows customers to borrow a set amount of money. There is
interest on the loan, and there is typically a fee per overdraft. At many banks, an overdraft fee can run
upwards of $35.

How a Bank Overdraft Works:

With an overdraft account, a bank is covering payments a customer has made that would otherwise be
rejected, or in the case of actual checks, would bounce and be returned without payment. As with any
loan, the borrower pays interest on the outstanding balance of an overdraft loan. Often, the interest on
the loan is lower than the interest on credit cards, making the overdraft a better short-term option in an
emergency. In many cases, there are additional fees for using overdraft protection that reduce the
amount available to cover your checks, such as insufficient funds fees per check or withdrawal.

Example of a Bank Overdraft:

Overdraft protection provides the customer with a valuable tool to manage their checking account. If
you're short a few dollars on your rent payment, overdraft protection ensures that you won't have a
check returned against insufficient funds, which would reflect poorly on your ability to pay. However,
banks provide the service because of how they benefit from it—namely, by charging a fee. As such,
customers should be sure to use the overdraft protection sparingly and only in an emergency.

The dollar amount of overdraft protection varies by account and by the bank. There are pros and cons to
using overdraft protection. Often, the customer needs to request the addition of overdraft protection. If
the overdraft protection is used excessively, the financial institution can remove the protection from the
account.

Merit:
HELPS IN KEEPING GOOD TRACK RECORD:

If a check was made on the basis of some amount to be received, and if it is delayed, the check does not
bounce due to inadequacy of funds. Hence, overdraft facility allows for a better payment history.
TIMELY PAYMENTS:

It also ensures timely payments and avoidance of late payments penalties as payments can be made
even if there is a lack of sufficient balance in the account.

LESS PAPERWORK:

It requires less paperwork that would usually be required in long-term loans as overdraft facility is easy
to avail.

FLEXIBILITY:

Overdraft facility has the advantage of flexibility as one may take it at any time, for any amount (up to
the limit allotted), and for even as less as one or two days.

BENEFIT OF LESS INTEREST COST:

The interest is calculated only on the amount of funds used. This allows for greater savings in the
interest cost compared to a normal loan taken for a fixed time period. While in other loans, interest is
required to be paid even if the money remains unused. In this case, the charging of interest starts with
the amount over drawn and it stops instantly when it is paid off.

Demerit:
HIGHER INTEREST RATES:

Overdraft facility comes at a cost. At times, the cost is usually higher than the other sources of
borrowing.

RISK OF REDUCTION IN LIMIT:

Overdraft facility is a temporary loan and undergoes regular revisit by the bank. Hence, it runs a risk of a
decrease in the limit or withdrawal of the limit. Reduction in the withdrawal of limit may happen usually
when company financials may represent poor performance; hence, the facility may be withdrawn
especially when the company may require it the most.

DEBTOR’S COLLECTION BECOMES LETHARGIC:

At times, availability of overdraft facility may make the company less strict on the collection of debtors’
payment. In other words, a company may not be too much on their feet to collect payments from
debtors, as immediate payment outflows can be managed by overdraft facility.
 Bank Draft
Definition:
A bank draft is a payment on behalf of a payer that is guaranteed by the issuing bank. Typically, banks
will review the bank draft requester's account to see if sufficient funds are available for the check to
clear. Once it has been confirmed that sufficient funds are available, the bank effectively sets aside the
funds from the person's account to be given out when the bank draft is used. A draft ensures the payee
a secure form of payment. And the payer's bank account balance will be decreased by the money
withdrawn from the account.

How a Bank Draft Works:

Obtaining a bank draft requires that the payer has already deposited funds equal to the check amount
and applicable fees with the issuing bank. The bank creates a check to the payee drawn on the bank’s
own account. The name of the payer (also known as the remitter) is noted on the check, but the bank is
the entity making the payment. A bank cashier or officer signs the check. A bank draft functions
similarly. Because the money is drawn upon and issued by a bank, a bank draft guarantees the
availability of the underlying funds. Buyers or sellers make or require payments through bank drafts as a
secure method of payment.

Example of a Bank Draft:

A bank draft can be required by a seller when the seller has no relationship with the buyer; a transaction
involves a large sale price, or the seller believes collecting payment may be difficult. For example, a
seller will require a bank draft when selling a home or an automobile. Of course, a seller might not
collect funds with a bank draft if the bank becomes insolvent and does not honor outstanding drafts, or
if the draft is fraudulent.

Merit: