Overdraft: Borrowing Without Asking, and What It Costs

An overdraft is money the bank lets an account go below zero by. Some are arranged in advance and some simply happen when a payment lands before the money does. A household usually reaches one through timing rather than through spending, and on a small, short shortfall almost all of what it costs is a flat fee rather than interest.

Here is what sits underneath that answer. On 24 April the Bhosale household's salary account went to minus Rs 3,170/- and stayed below zero for six days. Nobody had applied for anything. Nothing unusual was bought that week: what left the account on the 24th was the same Rs 3,725/- of groceries, fuel and eating out that left on the 3rd, the 10th and the 17th. The household could see the month getting thin. A week before any of it, on the 17th, Rs 4,000/- had already come in from the buffer savings account. An overdraft is a calendar outcome, and this one arrived at a household that was watching the calendar.

The question worth asking changes as a result. Nobody decided to borrow anything, so why the household borrowed is not the question. The question is why the month was shaped so that a large outgoing landed before a large incoming, and that question has an answer a household can see on a single sheet of paper before the month starts.

Four things decide what a month like April costs: whether an arrangement existed beforehand, how the charge splits between interest and a flat fee, how many dated instructions sit inside the days the account is short, and where in the month those days happen to fall.

What is an overdraft, and what is the bank doing when it allows one?

Start with the plainest possible picture. An account holds a number. Payments leave it and money arrives in it, and normally the number stays above zero because nothing can leave that is not there. An overdraftAn account balance below zero, which the bank has allowed. The money that took it there has already gone to whoever was being paid. is what exists when the number goes below zero anyway. A payment left the account, the account could not cover it, and the bank let it happen.

So what is the bank actually doing at that moment? The bank is paying somebody on the household's behalf with the bank's own money, and recording that the household now has to give it back. Paying on somebody's behalf for a fee is lending, whatever anybody calls it, and the giveaway is that it costs something. Nothing about the transaction looks like borrowing from the inside: no form was filled in, nobody was asked, and the household usually learns it happened when the statement arrives. But an amount that has to be given back, and that carries a charge for the days it is out, is a loan by every test that matters.

Think of a vegetable seller who lets a regular customer take a bag of onions on a Tuesday and settle on Friday. No agreement was written and nobody used the word credit. The seller is out of pocket for three days all the same, and if the seller adds ten rupees for the trouble, the ten rupees is the price of those three days. A bank does the same thing with a keyboard instead of a nod, and the price is on the statement.

Is an arranged overdraft the same thing as an account that has gone below zero?

The two arrangements share one word and are two different situations. An arranged overdraftA facility agreed with the bank in advance, with a limit and a set of terms fixed before anything is used. is a facility the household asked for and the bank agreed to, before there was any shortfall. There is a limit, there is a stated charge, and the terms were fixed while everybody was calm. When the account dips below zero inside that limit, everything that follows was decided in advance.

An unarranged overdraftAn account going below zero with no facility agreed beforehand. The bank decides on the day whether to let the payment through. is the other one. There is no facility. A payment arrives, the account cannot cover it, and the bank decides on that day whether to let it through or refuse it. Either way the household finds out afterwards. The bank allowing a payment through is not the same as a facility existing, and the difference decides both what happens next and what it costs.

The Bhosale household is in the first situation. There is a small arranged facility on the salary account, agreed when the account was opened and never used until April. The facility is why the account went to minus Rs 3,170/- rather than the payment being refused, and why the charge on the statement looks the way it does below.

How does a household end up overdrawn without deciding to borrow?

Through a calendar, almost always. Money arrives in an account on a small number of dates and leaves it on a large number of dates, and the two timetables are set by different people. An employer decides when a salary lands. A landlord, a lender, a school and a phone company each decide when their dated outgoingAn outgoing recorded with the day of the month it leaves on, rather than as a monthly total. The date is what makes it usable. leaves. Nobody coordinates any of it, and there is no reason the arrivals should fall before the departures.

April in the Bhosale household ran like this. The salary of Rs 39,800/- landed on the 1st, on top of the Rs 6,200/- already there, so the month opened at Rs 46,000/-. Then the dated outgoings started: rent of Rs 14,000/- on the 5th, the two-wheeler loan instalment of Rs 3,150/- on the 7th, cooking gas on the 9th, the first school term of Rs 9,600/- and society maintenance of Rs 1,200/- on the 10th, mobile and broadband on the 12th, clothes for the school year on the 14th, the recurring deposit on the 15th, electricity on the 18th, medicines on the 22nd, and groceries, fuel and eating out of Rs 3,725/- on each of four days. Rs 42,480/- of the Rs 53,170/- that left the account in April was gone by the 15th, and the second arrival of money, Rs 7,200/- from Ashok Bhosale's tailoring counter, was not due until the 30th.

Look at what that leaves. Between the 15th and the 30th the account receives nothing except the Rs 4,000/- the household moved across from its own buffer on the 17th, and it keeps paying out. The gap between the two arrivals is fifteen days wide and the ordinary weekly spending has to cross it. Nothing in that is a mistake. The month has a shape.

Why is the last week of the month the thinnest week?

Because of where the shape puts the low point. Draw April as a line and it is one long descent from Rs 46,000/- on the 1st to Rs 555/- on the 22nd, and then one more ordinary weekly payment tips it over. The descent is not steep in any single place. Every one of those twelve payment days takes something out and only two days put anything in, so the descent is relentless.

Pause on the 17th, the day the household acted. Rs 4,000/- came in from the buffer savings account and Rs 3,725/- of groceries, fuel and eating out went out the same day, so the line moves up by Rs 275/- and then carries on down. A Rs 4,000/- transfer cannot close a Rs 7,170/- gap between two arrivals, so a household can do exactly the right thing on exactly the right day and still be short. Being short here is not a failure of attention. The arithmetic sets a buffer of one size against a gap of another, and the size of a buffer and the size of a gap are separate subjects.

What did those six days actually cost?

The statement carried three separate lines, and the household's own contracted amounts are these. Interest of Rs 9/-. A usage feeA flat charge for using an overdraft at all. The fee is one size, and it does not grow or shrink with the amount or with the number of days. of Rs 250/-. Tax on that fee of Rs 45/-. Rs 304/- in total. The four amounts belong to this one invented household's contract. What a real account is charged sits in that bank's own schedule of charges and nowhere else.

Everybody assumes the interest is the problem, so take the interest first. Rs 9/- on Rs 3,170/- for six days works out at about 17.3 per cent a year. 17.3 per cent is an ordinary contracted rate, the sort of number a household would recognise, and it is not where the money went. In rupees the borrowing cost one rupee and fifty paise a day. A bus fare to go and ask about it costs more.

Why does the fee ignore how few days the account was short?

Because it is not measured in days. A flat fee is a charge for the event rather than for the duration, so Rs 250/- is the number whether the account was below zero for six days or for one afternoon. Add the Rs 45/- of tax on it and Rs 295/- of the Rs 304/- has nothing to do with how long anything lasted. The borrowing part is about three rupees in every hundred of the charge.

A very large number appears once the same charge is scaled up to a year, and it is worth handling carefully. AnnualisingScaling a charge that covered a few days up to what it would come to over a year, so two charges of different lengths can be compared. Annualising is a comparison device, not a prediction. the whole Rs 304/- over six days on Rs 3,170/- gives about 583 per cent a year. A flat fee does not have an annual rate at all. The arithmetic is correct and close to meaningless. A fee has a size. Scaling a flat fee up to a year measures how short the borrowing was, not how expensive the lending was, and the shorter and smaller the shortfall the more extreme the number gets. A household that reads 583 per cent and concludes it has been charged a fortune in interest has read a real number and drawn the wrong conclusion from it.

What happens when there is no arrangement at all?

A different thing happens, and it is the comparison that makes the Rs 304/- worth understanding rather than resenting. With no facility, a bank may simply refuse the payment. The money does not leave, the person expecting it does not get it, and the account is charged for the refusal. The refused instruction is a returned paymentA payment refused because the money was not there. The instruction fails, a charge is usually raised, and the amount is still owed to whoever was expecting it., and this household's own contracted charge for one is Rs 590/-.

Now count. A returned payment charge is raised per instruction, so what it costs depends entirely on how many dated instructions happen to sit inside the days the account is short. In April as it actually fell, exactly one did: the Rs 3,725/- of groceries, fuel and eating out on the 24th, the payment that opened the gap in the first place. One refusal is Rs 590/- and the Rs 3,725/- is still to be paid.

Move the same six day gap to the first week of the month and the count changes completely. Between the 5th and the 10th sit the rent of Rs 14,000/-, the loan instalment of Rs 3,150/- and the society maintenance of Rs 1,200/-. Three instructions inside the gap is three refusals, Rs 1,770/- on this household's own contracted charge, and all Rs 18,350/- is still owed afterwards. The same shortfall of the same size for the same number of days can cost Rs 304/-, Rs 590/- or Rs 1,770/- depending only on which days of the month it landed on.

When does an overdraft stop being a timing problem?

There is one question that separates the April sort of overdraft from a different situation entirely, and it is asked on one date. When the next money arrives, is the account back above zero? If it is, the shortfall was a gap between two arrivals and the gap has closed. The Bhosale household's April was clearedBrought back to zero or above. An account is cleared when the money that arrives is enough to cover what the account was short by. on the 30th when the Rs 7,200/- of counter takings landed and the balance went to Rs 4,030/-.

If the account is still below zero when the next money arrives, something else is true. The shortfall has survived one arrival, and a shortfall that survives an arrival is being carried forward rather than closed. An overdraft that outlives the next arrival of money has stopped being a question about dates and has become a question about amounts, and that is a different subject with a different answer. What carried debt is, how repayment works, what a loan costs across its life and what happens when repayment becomes difficult are all covered separately, under borrowing.

What would have shown this coming before April began?

One sheet of paper, and the household already had it. A list of outgoings with the day of the month written beside each one is not a budget and does not need a single decision made about it. The list is a timetable. Every figure on the list was already known: rent does not surprise anybody, an instalment is fixed, a school term is announced weeks ahead. Set the two arrivals against the list and the shape of the month is visible before the month starts.

Two things stand out on that sheet the moment the dates are on it. Rs 26,750/- lands in three instructions between the 5th and the 10th, being the rent, the loan instalment and the school term, six days apart and one week after the only large arrival of the month. And the second arrival sits on the 30th, the last day there is. A dated list does not tell a household what to do and it is not meant to; it turns a shortfall from something that happens to a household into something visible on a sheet three weeks earlier.

Four settings on the control matter. On the 10th, as it happened, the account is six days below zero, the low point is minus Rs 3,170/- and the charge on this household's contract is Rs 304/-. Move the term to the 25th and there are five days below zero, the same low point, and about Rs 303/-. Move it to the 28th and there are two days, the same low point of minus Rs 3,170/-, and Rs 298/-. Move it to the 30th, the day the counter takings arrive, and there are no days below zero at all, the lowest the account gets is Rs 4,030/- and there is no charge. The month's arithmetic fixes the depth of the dip and only its length moves, so the low point is the same minus Rs 3,170/- at every setting from the 5th to the 29th. What changes the answer completely is the date passing the day the second lot of money arrives. At every one of those settings the month closes at Rs 4,030/- and Rs 53,170/- has left the account.

Who else reads a month like this, and what are they reading it for?

A bank statement is read by more people than the person it belongs to, and what they take from it is not the closing balance. A lender assessing an application reads several months of statements and can see the movement inside each one: the low point, the number of days below zero, whether a shortfall cleared itself when money arrived or was still there a month later. A gap that closes on its own and a gap that does not are different situations rather than different sizes, and the difference between the two is exactly what a lender is looking for.

The household reads the same statement for something else again. The statement carries the low point and the six days, and neither appears in the closing figure of Rs 4,030/-. A closing balance answers one question honestly and cannot answer any other. The movement inside a month is worth reading whether or not anything is done about it.

The Bhosale household, Meghna Bhosale, Ashok Bhosale, Ira Bhosale and Sahyadri Freight Services Private Limited are invented.
Educational material. Not advice on any investment, tax, budget or market position.