Dubai: Are you looking for a small loan that can be drawn at any time? ‘Overdrafts’ are a short-term loan option that can prove useful for your day-to-day expenses and help you manage your cash flow flexibly.
An ‘overdraft’ loan is provided by a bank that allows a customer to pay for bills and other expenses when the bank account reaches zero. For a fee, the bank provides funds to the customer in the event of an unexpected charge or insufficient account balance.
“If your savings account enters a negative balance or if there isn't enough money in your account to cover a withdrawal, you can permit the bank to allow the transaction in the form of a predetermined loan known as an ‘overdraft’,” explained Anil Pillai, a UAE-based banking industry analyst.
“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.”
How do ‘overdrafts’ work? Key risks add up
Like other short-term loans, with overdraft loans, you borrow a lump sum of money that you’re required to pay back, usually with interest, in a short amount of time. You may need to start making repayments as soon as 30 days after taking out your loan.
“An overdraft is flexible - you only borrow what you need at the time which may make it cheaper than a loan. Moreover, it's quick to arrange and there is not normally a charge for paying off the overdraft earlier than expected,” added Pillai. “But there are risks to keep in mind.
“For instance, your bank could charge you more if you exceed your overdraft limit without authorisation. Also, the interest rate applied is nearly always variable, making it difficult to accurately calculate your borrowing costs.”
Additionally, unlike other types of loans you can only get an overdraft from the bank where you maintain your current or salary account. In order to get an overdraft elsewhere you need to transfer your bank account – which can prove to be a hassle when in need of immediate funds.
How is interest calculated on overdraft loans?
The interest of overdraft is calculated on the basis of the amount you withdraw. For instance, if you hold Dh50,000 in your account and withdraw an additional Dh10,000 aside from what is there in the account, the interest will be calculated on the amount withdrawn. But this depends on the limit set.
An ‘overdraft limit’ is the maximum you are allowed to withdraw. For example, you might have a bank account balance of Dh5,000 with an overdraft limit of Dh500. It means that you can spend up to Dh5,500, but you can't withdraw or request for an added amount if the payment exceeds the limit.
In the UAE, the interest rate charged on an overdraft loan averages at 1.5 per cent per month, which amounts to 18 per cent per year. In comparison, a credit card charges between 2.5 per cent and 3 per cent monthly, which is equivalent to 30 per cent to 36 per cent annually.
But how is a bank overdraft paid back? Unlike other loans, no minimum monthly re-payments are required when you take an overdraft loan. The overdrawn amount is paid off by deposits into your account, for example when your salary is paid in on a date agreed with the bank beforehand.
Downsides outweigh upsides to using ‘overdrafts’
“Having multiple overdrafts on your account or having your account charge off could negatively impact your consumer reports making it more difficult for you to open new bank accounts or borrow money in the future,” explained Jose Paul, an Abu Dhabi banker with over two decades experience in the field.
“An ’overdraft protection’ service ensures that your account doesn’t go into negative. But it often comes with a significant fee and interest which, if not paid off in a timely manner, can add an additional burden to the account holder.”
According to multiple surveys conducted worldwide, customers who had ‘overdraft protection’, in fact, often paid more in fees than those without it. So to put it simply, unless absolutely necessary, it would be prudent to use ‘overdrafts’ only for immediate cash needs that can be repaid back quickly.
The risks of ‘overdraft’ loans often outweigh the perks as you may end up paying fees and interest charges if you go over your agreed limit, and this can quickly add up. Also, borrowing limits are much lower than with a loan and your bank can cancel your overdraft any time, hence doubling the risks.
Bottom line?
“If you think that you can repay the debt in a shorter period of time then choosing the overdraft facility will prove cost effective for you. But if in case you want a longer period of time to clear your debt then the personal loan would be a better option,” added Paul.
“In other words, overdraft loans are probably more appropriate for long-term funding as an overdraft is likely to cost more than a loan for a long-term purchase. So while it can help pay bills and can be useful in emergencies, overdrawing should be avoided if possible to avoid penalties.”
A key factor to bear in mind is that if you are unable to pay the outstanding overdraft amount, then the bank has the right to deduct the balance from your existing savings or current account. To ensure that an overdraft doesn’t hurt you financially, borrow with a repayment plan in mind.
“When there is a possibility where you might need multiple personal loans, it is better to choose an overdraft account. However, if you are going for just one loan which has a larger amount to be borrowed and pay back over a longer term then you should consider a personal loan,” noted Pillai.
