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What is a business overdraft?
A business overdraft is a short-term solution to meet small business needs. It is a line of credit that gives businesses access to a set amount of money that can be used to finance unplanned expenses. This gives businesses the flexibility to adapt and change as their cash flow does.
How does it work?
Having a business overdraft means that your business has access to a pool of funds which can be used at any time. It is similar to a business credit card with some exceptions. You are only charged interest on the money you use until it is repaid. This means the money that is not used remains interest free.
Types of business overdrafts
Secured Business Overdraft
A secured line of credit involves business assets being allocated as collateral security for the money that is lent. These are usually short-term assets rather than capital assets. The lender may take on ownership of the collateral if the business fails to pay back the balance.
Unsecured Business Overdraft
An unsecured overdraft typically requires a personal guarantee and general lien to secure the account rather than assets. This type of line of credit requires businesses to have a strong credit profile and a good track record. Unsecured overdrafts may also have higher interest rates than secured overdrafts.
Business overdraft vs term loans
A business overdraft and a business loan are very similar in the respect that both supply a business with funds which must be paid back. The difference lies in the approach.
An overdraft provides access to funds up to a maximum amount. Businesses may then use these funds as they need them for business expenses. Any money used must be paid back with interest. If businesses do not use the full amount, they can borrow against the overdraft account again when they require additional funding. Interest rates are often high with an overdraft and are best suited to smaller, short-term business expenses.
In comparison, a business loan is a fixed amount of funds the business borrows as a lump sum. The loan is paid off over a prearranged amount of time until the loan plus interest is completely paid off. Loans typically offer larger amounts and are ideal for costly business expenses.
Applying for a business overdraft
When applying for a business overdraft the lender will require a range of documentation to ensure the businesses eligibility and creditworthiness. Some of these documents may include:
- Business licence
- Tax returns
- Bank statements
- A business bank account
- Other financial documents
Things to be aware of
Due to the nature of the overdraft product, borrowing more than you can afford is a dangerous mistake commonly made by businesses. It is very easy to fall in to deeper debt when taking out more money than what you require.
Don't take too long to pay back funds used. Overdraft accounts tend to have higher interest rates than other borrowing options. Therefore, the longer you take to repay the funds, the more interest and charges that will accumulate and the more expensive it gets.