Pros and cons of business overdrafts

It’s a term you may have come across before, but what exactly is a business overdraft? Essentially it’s a line of credit attached to a business bank account or debit card which allows businesses to draw on money (up to an approved limit) beyond what they actually have in the account.

Businesses then only need to pay interest on the amount of money they’ve overdrawn, making it a useful cash flow solution in many situations. For example, a business overdraft could be used for:

• Paying employees
• Purchasing stock
• Settling invoices
• Covering other expenses

So now you know what a business overdraft is, you may be wondering: what are its pros and cons and are there any other funding solutions that might be a better fit for your business? Read on for a breakdown.

Safety net - One of the main benefits of a business overdraft is that you’ll only need to pay interest on the money you actually overdraw, so it could act as a relatively low cost (depending on fees) safety net that you don’t even have to use.

Flexible term limits - Generally, you’ll be able to talk to your lender about the period you’d like the business overdraft to be available for and you may even be able to get it renewed. You’ll also be able to close it at any time, though if you do, you’ll obviously have to pay off any outstanding balance or fees.

Cash flow - A business overdraft could help you fund a range of business needs when you don’t have your own money on hand, especially if they’re unexpected expenses.  

Choice of security - Lenders tend to offer both secured and unsecured business overdrafts. The benefit of a secured overdraft is that you’ll likely pay a lower interest rate in exchange for offering property or another asset as security, while for an unsecured overdraft you’ll tend to be charged a higher interest rate but you won’t need to put up any collateral.

Interest rates - While you won’t pay any interest on the balance of the overdraft you don’t actually use, you will be charged an interest rate (generally a daily rate) on the money you do draw upon. It’s also worth noting that business overdraft interest rates tend to be higher than business loan interest rates, so it could be worth weighing up both as business funding solutions.

Fees - Aside from an interest rate, you may still need to pay business overdraft fees - even if you don’t touch it! These could include application fees, annual fees (generally charged as a dollar figure or as a percentage of the whole limit) and late payment fees.

Quick termination - While you’ll be able to call off your business overdraft at any time, the same goes the other way too, as the overdraft could be called in by your bank at any time.

While a business overdraft may be a great solution for some business funding needs, there are also a number of alternatives that may be worth considering depending on your business’ specific needs.

Business loans

Taking out a business loan is a popular option for businesses in need of funding over a longer period of time - either for cash flow, or for financing large purchases.

Like regular loans, business loans are taken out over a fixed period, with borrowers required to make regular interest repayments (which can be at a fixed or variable rate) on the balance of the loan. Similarly to business overdrafts, business loans can either be secured or unsecured, and they also tend to come with a number of fees.

However, business loan interest rates are often lower than those of business overdrafts, so they could be a more cost-effective option for businesses that have known expenses they need to fund, and don’t require the flexibility of a business overdraft.

Business credit cards

Business credit cards are a popular way for businesses to manage cash flow and pay for smaller expenses. Like business overdrafts, business credit cards are essentially a line of credit with a pre-arranged limit, an interest rate and a number of fees. 

Unlike overdrafts, many credit cards also give businesses the chance to earn rewards points for the purchases they make which can then be redeemed for travel or retail rewards.       

Ready to start comparing funding options for your own business? Make life easy for yourself by comparing business bank accounts, business loans and business credit cards on Mozo’s handy comparison tables.