Finance explained: What is an overdraft?

Many of us have smartphones and use them to track our banking. The big four Australian banks all have apps for Apple and Android, and many of the smaller banks and credit unions are starting to offer them as well. Occasionally, you might get notifications about offers through your apps. One product banks offer their customers is an opportunity to raise their overdraft. But what is an overdraft? Let the team at Smallloans.com.au tell you plainly in this instalment of Finance Explained.

Overdrafts put simply

Simply, an overdraft or “going into overdraft” is when you take out more money from your bank account than you have in it. For example, if you take out $100 from your account which has a balance of only $50, you will have an overdraft of $50. For personal accounts, the bank will honour the transaction more often than not. This leaves you with a negative balance. You must pay back the balance by depositing more money into your account to cover the debt. Usually they want this done as soon as possible. Banks may charge you an overdraft fee, an establishment fee or interest on the amount overdrawn. This is the most common type of overdraft. However, there is another type that’s more common among business account holders and home loan borrowers.

The two types of overdrafts

The example of the overdraft mentioned earlier is called an “unarranged overdraft” – something that happens unexpectedly. But there is another type, called an “arranged overdraft.” This is something you apply for, like you would a credit card or personal loan. Arranged overdrafts often come with limits ranging from $500 for personal accounts up to $10,000 or more for business customers.
Arranged overdrafts also come with interest and fees when you do overdraw on your account. You will have to speak to your bank directly about those fees. In some cases, the interest rates on arranged overdrafts can be reduced by putting up a security (such as a car or a house) as well. As always, unsecured loans mean a bigger risk for the bank, which means higher interest rates.

Available balance vs. “real” balance

One confusing aspect about personal finance is the concept of “available balance” vs. your “real” balance. You often see this on your ATM slip. An available balance isn’t always showing you what’s actually in your account. This may be higher than your “real” balance, as it may be your real balance plus cheques that have yet to clear or other transactions that have not yet been processed. Let’s say you have an available balance of $100. This is made up of $50 of savings and a $50 cheque that’s yet to clear. Let’s say you withdraw that entire $100. Despite having a $100 “available balance,” you will still be overdrawn by $50. You may lose much of that remaining $50 when it does clear to overdraft fees and charges.

Overdrafts can become traps

If you are constantly overdrawing on your account, it can quickly become a trap. You will be paying back interest, dishonour fees and other charges associated with overdrafts over and over again. These overdrafts, if they are common, may end up damaging your credit history. It makes sense to seek alternative forms of credit, such as payday loans and small cash loans. These products may end up cheaper than making an overdraft. They can also keep your bank account from going into overdraft in the first place. Other products such as small loans are lent out by licenced credit providers must show you exactly what you must pay back up front. This is in contrast to some the terms and conditions of “unarranged overdrafts,” which may be hidden in the credit contract that you have with your bank or credit union.

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