Current account versus overdraft: what the difference costs

An overdraft is usually described as a feature of a current account, which makes it sound like a setting that can be switched on. It is closer to the opposite: it is a loan, sanctioned on its own terms, that happens to be delivered through an account you already operate.

The distinction is easiest to see in whose money is moving. When a current account is in credit, every rupee in it is yours; the bank is holding it and owes it back. The moment the balance passes below zero into a sanctioned limit, the money leaving the account is the bank's, lent to you, and the balance is no longer a deposit but a debt. Nothing on the screen announces the change of category. The same account number, the same app, the same statement — and a different legal relationship on either side of zero.

That is why the two cannot be compared as alternatives in the way the question is usually framed. A business does not choose between a current account and an overdraft; it operates a current account and may additionally be sanctioned a facility on it. What follows is what that facility costs and what the cost turns on. It is not a recommendation about whether to take one, which depends on facts specific to a business and belongs in a conversation with its banker.

On the credit side, the account is doing custody and transmission. It holds your balance, executes your instructions, and provides the record of both. Its costs are the ones attached to that service: a minimum or average balance requirement, a charge when the balance falls short of it, allowances on cash handling beyond which charges apply, and per-transaction charges that vary by rail and channel.

What it does not do is pay you. Interest is not paid on current account balances, so a business holding a permanent cushion in one is holding it in the single place designed to return nothing on it. That is not an argument for holding less; a cushion has an obvious operational purpose. It is the reason arrangements exist to link a current account to a deposit and move surplus balances out automatically, and the reason the cost of an overdraft has to be compared against something — usually against what the same money would have been doing sitting idle, or against the cost of the alternative, which for many small businesses is delaying a payment to a supplier.

The useful frame is that the account side is priced for access and the facility side is priced for risk. They are separate charges for separate things, and they appear on the same statement, which is a large part of why they get conflated.

An overdraft is a sanctioned limit you may draw below zero into, with three properties that distinguish it from a term loan.

Interest is charged on the amount actually drawn, computed on daily balances, not on the limit sanctioned. A limit of ten lakh rupees used to the extent of one lakh for six days costs interest on one lakh for six days. This is the property that makes the headline rate a poor guide to the cost, and it cuts both ways: it is why an intermittently used facility is cheaper than the rate suggests, and why a permanently drawn one is a term loan being carried at overdraft pricing with no amortisation.

There is no repayment schedule. Nothing obliges you to bring the balance back to zero by a date, and the facility does not reduce itself. The discipline that a term loan imposes structurally has to be imposed by the borrower here, which is the mechanism behind a facility that was taken for a seasonal gap and is still drawn three years later.

And it is generally repayable on demand and subject to periodic review. A sanction is typically for a defined period, renewable, and the sanction letter will say on what terms it can be recalled or reduced. That clause is the one most often unread.

Comparing facilities on the interest rate alone reliably understates the difference between them, because several of the costs are not in the rate.

Interest is the largest component and is a function of utilisation, as above. Then there is a processing or arrangement fee at sanction, and typically a renewal fee at each annual review — both usually a percentage of the limit rather than of what is drawn, which means an unused limit still costs something every year.

Costs of creating the security sit outside the bank's own charges entirely. Where a facility is secured on property, there are valuation, legal and charge-creation costs and, depending on the state and the instrument, stamp duty on the security documents. These are one-off but not small, and they are frequently left out when a business compares one bank's offer to another's.

Some sanctions carry a commitment or non-utilisation charge on the undrawn portion, on the reasoning that the bank has set capital aside against the whole limit.

And default carries its own charge. The Reserve Bank has directed lenders to levy penalties for non-compliance with loan terms as penal charges rather than as penal interest added to the applicable rate, which stops them compounding into the outstanding balance. The current text of that direction and the bank's own published policy are the authorities on how it applies.

Two businesses can hold identical facilities at an identical rate and pay materially different amounts, and the variable is the shape of the drawing rather than anything in the sanction.

A facility drawn for a few days around a payment cycle and repaid when receipts arrive is being used the way the instrument is designed: interest accrues for the days the money was out. A facility drawn once and left outstanding is being used as a permanent loan, and because nothing forces it down, the balance becomes a floor rather than a fluctuation. The cost difference between those two patterns over a year is far larger than the difference between two banks' rates.

This is also where cash credit differs from a plain overdraft in a way that matters to the cost. Cash credit is sanctioned against current assets, and the amount actually drawable — the drawing power — is recalculated from periodic stock and receivables statements. So the usable figure moves with the business even while the sanctioned limit stays fixed, and a business that plans against the sanctioned limit rather than against drawing power can find the available amount has fallen exactly when trading conditions made it need more.

The practical implication is that the question worth asking about a facility is not what it costs but what it costs at your pattern of use.

The document that determines nearly everything above is the sanction letter, and it is the one most businesses read once at signing.

Six things in it are worth locating specifically. The limit, and whether it is a plain overdraft or cash credit, because that decides whether drawing power applies. The basis of interest — which reference rate the pricing is linked to, what the spread is, and how and when it resets, since a floating facility's cost changes without a new letter. The review or expiry date, and what happens on it. The security, and any personal guarantee, which is a different exposure from the business's own. The repayable-on-demand or recall clause, and the notice attached to it. And the covenants: what you have undertaken to submit, typically stock and receivables statements at a stated frequency, and what happens if you do not — because for a cash credit facility, failing to submit a statement can itself reduce drawing power.

None of this is unusual or hidden; it is standard commercial documentation. But it is the only place the actual terms exist. A general article can explain what these clauses are for; only the letter says what has been agreed, and a facility whose recall terms are unknown to the borrower is a facility being carried on an assumption.