When it comes to taking a loan for a business, the owner or the corporate has two possibilities. They can either select long-term finance like a loan against property (LAP) or decide on flexible funding. Flexible funding includes Cash Credit (CC) or Overdraft (OD). Long-term funding has a lower interest rate, however flexible funding allows you to save interest by depositing extra funds in the account and paying interest only on the amount you require.
Did you know?
An overdraft facility is offered to companies to withdraw money that exceeds the amount available in their accounts.
What is an OD Account
The full form of OD Account is Overdraft Account. It's a form of account where a bank allows a transaction or allows you to withdraw money even if you don't have money in your account. The bank allows you to borrow a specific amount of money. The bank levies an overdraft fee or an interest on the amount you have borrowed. You are responsible for paying that amount to the bank within the time frame it mentions. It is a current account. On the amount due by the end of the day, one must pay interest.
What is an Overdraft facility?
An overdraft is a financial facility or instrument that allows you to withdraw money from your bank account (savings or current) even if your account balance is zero. When you use an overdraft, the bank charges you an interest rate, just like any other credit facility. To get an overdraft limit, you usually have to pay a predetermined interest rate.
Features of an overdraft facility
- Banks provide overdrafts up to a certain amount, which varies from borrower to borrower.
- A running account with an overdraft limit is one in which you can deposit or withdraw money at any moment up to the set limit.
- The bank charges a predetermined rate of interest on the overdraft amount used by the borrower. Interest is calculated on a daily basis and billed/debited to you monthly. If you don't pay the due overdraft amount, the interest rate will go up.
- Unlike most loans, where you must pay a prepayment penalty if you pay off your loan early, banks do not charge prepayment penalties on overdraft limits. You can pay off the overdraft in full without incurring any prepayment penalties if you pay it off in installments.
- You can pay off your overdraft in various quantities whenever you have the funds. When it comes to overdraft limitations, the EMI method, which is common with most loans, does not apply.
- While there is no set monthly repayment schedule for overdraft loans, the amount you owe should not exceed your overdraft limit.
- Overdraft limitations are available to joint borrowers. Both applicants, however, share equal responsibility for repaying the sanctioned Overdraft limit.
Different types of collateral accepted by banks against overdraft loans
- Overdrafts against your house or property
- Business inventory or equipment
- Accounts receivables - Banks accept the security of invoices that have not yet been paid. When the payment is done it gets credited to the Bank
- Stocks as well as Investment shares
- Insurance policies
Also read: All About UPI– United Payments Interface
Types of overdraft
Overdraft against Property
Your home is used as collateral for an overdraft facility. Customers with a house loan who require funds to pay off their current debt are also eligible for an overdraft. The property is assessed, valued, and surveyed before the residence is approved as collateral. Due to the fact that overdraft funds are issued against property as collateral, they are not disbursed promptly. The approved overdraft amount is normally between 40% and 50% of the property's value. When providing an overdraft against your home as collateral, your credit history and repayment capacity are also taken into account.
Overdraft Facility against Fixed Deposits
As compared to acquiring an overdraft using your home as collateral, getting an overdraft using Fixed Deposits (FDs) and life insurance policies as collateral is simple. One of the reasons is that evaluating a property takes time. In any scenario, the lender prefers overdraft against FD because the customer's FD account is with the lender and the lender knows the consumer better. If you take out an overdraft against your fixed deposit, you'll be able to get a bigger percentage of the sanctioned amount, around 75%. If you hold an FD as collateral, the interest rate charged is also lower. Banks usually charge 2% more interest than the interest you earn on a fixed deposit if you retain it as collateral
Overdraft against Insurance Policy
If you use your insurance policy as collateral for an overdraft, the amount you can borrow is determined by the surrender value of your policy. The loan to value of an insurance policy is higher than the loan to value of a fixed deposit, which means that if you keep your insurance policy as collateral, you will obtain more money sanctioned from the bank than if you hold a fixed deposit of the same amount as collateral.
Overdraft against Equity
Although equity is not recommended as a form of security, it can be used to get an overdraft facility. The reason for this is that stock is market-dependent, and so its value varies. As a result, the percentage of overdrafts approved with equity as security is lower.
Overdraft against Salary
Banks also provide overdrafts against salaries for salaried people. An overdraft limit of up to 2-3 times your salary is possible, but this varies by bank. To qualify for such an overdraft, you must have a salary account with the bank in question. A short-term lending facility is another name for this type of facility. The major source for banks to sanction borrowing restrictions is the overdraft balance sheet.
What is a Cash Credit Facility?
A Cash Credit (CC) is a type of short-term borrowing available to businesses. In other words, cash credit is a bank's short-term loan to a business. It allows a business to withdraw funds from a bank account without having to maintain a credit balance. The account can only borrow up to the amount specified in the borrowing limit. In addition, interest is levied on the quantity borrowed, not the total amount borrowed.
Features of Cash Credit:
- Borrowing limit: A cash credit has a borrowing limit that is established by the borrower's creditworthiness. A corporation can withdraw funds up to the amount of money it has borrowed.
- Interest on running balance: Unlike other traditional debt financing options such as loans, the interest levied on the cash credit account's operating balance, not the overall borrowing limit, is charged
- Minimum commitment charge: Regardless of whether the borrower uses the available credit, the short-term loan comes with a minimum price for establishing the loan account. Banks, for example, often include a stipulation requiring the borrower to pay a minimum amount of interest on a predetermined sum or the amount withdrawn, whichever is greater.
- Collateral security: Stocks, fixed assets, and real estate are frequently used as collateral to secure credit.
- Credit period: Cash credit is usually granted for a maximum of 12 months before the drawing power is re-evaluated.
Examples of Cash Credit
Company A is a phone manufacturer that owns and maintains a facility where it spends money on raw materials before turning them into completed goods. The finished goods inventory, on the other hand, is not sold right away. The capital of the corporation is trapped in inventory. Company A gets a cash credit loan to pay its expenses while waiting for its finished goods inventory to convert into cash, allowing them to run their operation without a shortage.
Advantages of Cash Credit
1. Working capital financing source
Cash credit is an important source of working capital financing since it eliminates the need for the company to worry about liquidity.
2. Simple to set up
A bank can readily arrange it if collateral security is available to be pledged and the realizable value of that security can be easily assessed
Withdrawals from a cash credit account can be made as often as needed up to the borrowing limit, and deposits of surplus cash into the account reduce the amount of interest owed to the company.
4. It is tax-deductible
Interest payments are tax-deductible, which lowers the company's overall tax burden
5. Amount of interest charged
Because the interest payable on a cash credit is only on the amount used or the minimum commission charge, the borrower's financing costs are reduced.
Disadvantages of Cash Credit
1. A high-interest rate:
When compared to typical loans, the interest rate imposed by a loan on cash credit is extremely high
2. Charges for a minimum commitment:
Regardless of whether the company uses its cash credit or not, the borrower is subject to a minimum commission charge.
3. Difficulty in obtaining the loan:
The borrower is given a short-term loan based on his or her turnover, accounts receivable level, predicted performance, and collateral security. As a result, it may be difficult for new businesses to get it.
4. Financing source that is only temporary:
The loan is a short-term funding option. It is impossible for a corporation to rely on it for an extended period of time. The loan must be renewed once it expires under new terms and circumstances.
Difference between Overdraft and Cash credit
Cash Credit Account
It is usually given as security for stock, debtors, and other assets
It is usually granted in exchange for the security of a fixed asset.
Along with financial statements, the maximum amount is computed as a percentage of sales and stock. For example, a bank allowed cash credit up to 80% of stock 20% of revenues.
The maximum amount that can be borrowed is determined primarily by financial records and security
It should only be used for business purposes.
It can be used for anything
Balance sheet, profit & loss account, and, VAT reports must be sent to the bank on an annual or quarterly basis.
After clearance, financial statements are usually not required to be resubmitted
It does not get smaller over time.
Dropdown Overdraft has a monthly drop in the level of overdraft protection (DOD)
Stock insurance is usually required.
Property insurance is usually necessary.
Taking advantage of the cash credit option frequently necessitates the creation of a new account
Banks typically initiate overdrafts in existing current accounts.
The interest rate on a savings account is usually lower than on an overdraft account
The interest rate on a credit card is usually higher than on a cash credit card.
The details mentioned in this article provide complete clarity on how banks offer a credit facility in the form of cash credit or an overdraft. We hope this has given you an insight into the requirements that qualify a person to avail of these facilities. Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.