Legal Definitions - overdraft

An overdraft occurs when money is withdrawn from a bank account, or a payment is made from it, for an amount greater than the current balance available in that account. Essentially, it means spending more money than you have in your account, resulting in a negative balance.

Banks often offer different ways to handle overdrafts:

• Sometimes, an overdraft happens unintentionally when a transaction is processed despite insufficient funds, leading to the bank covering the difference and typically charging a fee.
• Alternatively, an overdraft can refer to a pre-arranged credit facility, often called overdraft protection or an overdraft line of credit, which allows an account holder to intentionally go into a negative balance up to a certain limit. This facility acts as a short-term loan, usually with interest charges, to provide flexibility for managing finances.

Here are some examples illustrating the concept of an overdraft:

• Example 1 (Unintentional Overdraft):

  Sarah checks her bank account and sees a balance of $75. She then uses her debit card to pay for groceries costing $80, forgetting about a small subscription service charge that cleared earlier, leaving her actual balance at $70. The grocery store transaction goes through, causing her account balance to drop to -$10. Her bank then charges her a $35 overdraft fee. In this scenario, Sarah has created an overdraft by spending more than she had, and the bank has covered the difference, resulting in a negative balance and an additional fee.

• Example 2 (Overdraft Protection):

  Mark has a checking account with an attached overdraft protection service linked to his savings account. His checking account balance is $150. He writes a check for his rent, which is $1,000. Instead of declining the check or incurring a large fee, his bank automatically transfers $850 from his savings account to his checking account to cover the rent payment. This transfer prevents an overdraft in his checking account by utilizing his pre-arranged protection, ensuring the payment clears without issues.

• Example 3 (Business Overdraft Facility):

  A small graphic design studio, "Creative Canvas Inc.," has a business checking account with a pre-approved $5,000 overdraft facility. In a particular month, several large client payments are delayed, but the studio still needs to pay its employees and utility bills. Their account balance drops to $500, but they have $3,000 in immediate expenses. The overdraft facility allows them to make these payments, temporarily bringing their account balance to -$2,500. This provides the necessary short-term liquidity, and they will repay the negative balance with interest once the delayed client payments arrive. Here, the overdraft is a planned financial tool to manage cash flow fluctuations.