An overdraft? Is that some kind of vegetable? 🥦
No, not exactly.
'Overdraft' is one of those words that can seem confusing and technical on the outside, but once you’re on the inside it actually makes sense.
In fact, understanding what a bank overdraft is can go a long way. It’s good to know when they can be a helpful tool, but also when they turn into unexpected burden. Knowing when each is the case is a big step towards financial empowerment. 💪
In this article we’ll be using plain English and everyday concepts to explain what an aubergine, sorry overdraft is. No need for a finance degree for this one.
Coffee and overdrafts ☕
Picture it: you’re on your way to work and decide to pick up a quick coffee at the closest Coffee Bean & Tea Leaf. The coffee is just getting ready and you swipe your card on the card machine… Declined. 😱
You try again. Declined again. You quickly check your bank account and realise you have RM5 left in your account. Oops. Too many coffees and it’s close to the end of the month. 🤷♀️
Usually you would then have to transfer money into your account, desperately search for hidden coins in your wallet or ask a friend to help you out. Your account stops at 0, and there’s no running from that. We’ve all found ourselves in situations like this one, and sadly it can be pretty common.
Banks jumped at this opportunity to offer a snazzy product called ‘overdraft’ or ‘overdraft facilities’. Suddenly, your bank account no longer stops at 0, it goes on into the negatives. You get a little extra, a little over (see that?) what you actually have.
Woohoo! No more cold panic when your card gets declined. You buy your coffee and your account now says - RM5.
Yes, no more panic, but there is a catch. This is borrowed money. When you take money out of your overdraft, you are borrowing money from the bank. And that can be expensive. 🙄
How expensive are overdrafts?
So you can now afford that coffee. But before you go out and get the next new iPhone, it’s good to be aware of the fees and limits.
First of all, your bank overdraft will go up to a certain limit. So spending RM500,000 might cause a bit of an issue. The bank sets a limit depending on what ‘collateral’ (something of yours which the bank will take from you if you don’t pay up, like a house or investment) you offer and what your personal situation is like.
Second of all, that overdraft is not free. You can borrow that RM5 but you’ll have to pay ‘interest’ on top of that. More on that further in the article 👇
The interest calculation
The interest is basically the price you pay to the bank for loaning you money. It usually comes as a total percentage of what you owe.
The amount of interest you’ll pay on your overdraft depends on how much you borrow. If your balance is at - RM5, that means you’ve borrowed RM5. The interest rate differs from bank to bank. They usually use a formula based on their ‘base rate’ + interest rate.
It’s good practice to look them up and be aware of the interest rate before taking money out of your overdraft. It’s also good to look at other charges the bank may add on.
If we look at a usual bank's personal overdraft, we can see that there are other charges:
1% extra if you fail to pay on time
A ‘commitment fee’ if you don’t use up your entire overdraft
Repossession of collateral if you fail to pay
The point here is that fees can quickly increase. What at first might only be RM5 can quickly increase to RM20 or more. Suddenly that coffee is a lot more expensive than it should be. ☕
So, should I take an overdraft?
To get an overdraft you must first apply for one with your bank, so it’s not a 2-click process. Although overdrafts can offer flexibility and freedom in certain situations, the high fees and loss of control can lead to unexpected expenses down the road.
The bank has control over your money and can change, revise or remove your overdraft at any time. Without discipline, an overdraft can easily become a long-term financial burden.
An alternative solution: why not build up your 6 month emergency fund? Here’s our step by step guide to building your very own nest egg. 🥚