1. What is an overdraft?
An overdraft is a sum of money extended to you as credit by your bank, set at a pre-arranged limit when your account balance drops below zero.
Banks usually charge interest on any amount of overdraft you use, but the terms and price of overdrafts will vary between providers.
You can use a bank overdraft to manage your cashflow, but it is probably not suitable if you’re looking for long-term funding.
2. The application process
Obtaining an overdraft is similar to applying for a loan from your bank. Most lenders require you to:
- share the financial risk by providing capital up to the same amount as you want to borrow, demonstrating your commitment and providing a contingency for repayment if things go wrong
- provide security for borrowing requests - eg personal or business assets, such as your home or business premises
- provide personal guarantees if you run a limited company, and the business cannot offer adequate security
- keep them informed of your progress, particularly if you envisage any changes or problems affecting your overdraft facility
- have a comprehensive business plan and cashflow forecast for larger borrowing requests
- have a good credit record, including a good payment record with other creditors
If you’re looking for an overdraft, the bank will be especially keen to see that you make responsible use of it and don’t exceed the limit.
It is important to inform the bank if your company is having financial difficulties. It is preferable to renegotiate new terms for an account to breach a term such as an overdraft facility.
3. Pros and cons
- an overdraft is flexible - you only borrow what you need at the time and it's usually quick to arrange
- you are only charged interest when you use the overdraft facility and banks don’t normally charge you for paying off the overdraft earlier than expected
- overdraft facilities can be reviewed regularly
- if you have to extend your overdraft, you usually have to pay an arrangement fee
- your bank could charge you if you exceed your overdraft limit without authorisation and you may get penalty charges for any cheques that bounce
- the bank has the right to ask for repayment of your overdraft amount at any time, although this is unlikely to happen unless you get into financial difficulties
- security may still be required
- unlike loans, you can only get an overdraft from the bank where you maintain your current account. In order to get an overdraft elsewhere, you need to transfer your business bank account
- the interest rate applied is nearly always variable, making it difficult to accurately calculate your borrowing costs
- if you don’t use your overdraft, it may be reduced by the banks at short notice. This is unlikely to happen unless you get into financial difficulties
4. Common mistakes
An overdraft should only be used as a short term funding option as it can be more expensive than a longer term loan and is repayable on demand. Continued reliance on overdraft facilities suggests that the business needs to review its working capital management and put in place improved cash management procedures and/or secure longer term finance.
Your bank may turn you down if you can’t:
- explain why you want the overdraft and how you will use it
- demonstrate that you understand the risks and that you have taken steps to reduce their effect
- explain who looks after your business’ finance and that you have solid financial systems in place
- provide financial data, ie accounts, budgets and forecasts
- offer security against the overdraft facility