10.4 Overdrafts

Question 1

What is an overdraft?

Answer 1

A pre-agreed facility provided by banks and financial institutions that allows a withdrawal of money in excess of the account’s credit balance.

Question 2

How do banks make profit from overdrafts?

Answer 2

There is usually an annual arrangement fee plus interest.

Question 3

What is the “London Interbank Offered Rate”? (aka LIBOR)

Answer 3

A benchmark rate at which a selection of the leading banks on the London money market are prepared to lend to one another.

Question 4

What are the advantages of an overdraft for short-term financing?

Answer 4

• quick and easy to arrange
• can be cleared at anytime without early repayment charges
• back-up against unexpected expenditure
• do not require giving up a share of the business
• interest/arrangement fees are tax deductible
• overdraft balance is not usually used in calculating financial gearing

Question 5

What are the disadvantages of an overdraft for short-term financing?

Answer 5

• interest is unpredictable as it depends on a variable interest rate on the amount overdrawn on each day of the charging period
• repayable on demand without prior notice
• high rate of interest
• annual arrangement fee
• large overdrafts will need t be secured against assets
• failure to pay can affect credit score