Sometimes a contingency fund won't be enough to take care of a financial emergency. Though most people keep three to six months' expenses aside as per their financial advisors' recommendation, they sometimes need to raise money for a short period to meet an emergency.
Many of them turn to their banks for an overdraft against their assets to raise short-term funds. "Overdraft is a good instrument to raise funds for a short term and if used wisely, it can help you tackle your short-term financing needs smartly.
Banks offer overdraft facility to individuals against assets such as property, securities and life insurance policies. The individuals have to pay interest on the amount depending on the period.
For the beginners, overdraft facility is a credit line given to an individual against his assets. For example, you can mortgage your house with a bank and get a borrowing limit sanctioned against it.
If your house is worth Rs 1 crore, depending on your repayment capacity and other factors such as remaining life of the property, bank's rules, bank may give you a limit of Rs 50 lakh.
The money is not disbursed to you immediately. It almost works like an approved loan. As and when you want, you can keep withdrawing money from this overdraft account. You have to pay interest on the money borrowed for the time you have availed it.
You can keep borrowing and repaying your money as long as the bank is willing to offer such overdraft facility to you. The rate of interest payable on such facilities against property usually ranges between 12 and 14% per year.
You can offer the bank assets such as your insurance policies, shares and bonds, bank fixed deposits. The rate of interest does vary for each of these collaterals.
For example, you may end up paying around 12 to 14% for an overdraft against property. Banks charge one percent more than the rate payable on the fixed deposits for the overdraft against fixed deposits.
For example, if your fixed deposits are earning you 8%, an overdraft availed against them will make you pay at the rate of 9% for the period you avail the credit. "This credit facility is secured by an asset and the rate of interest payable is much cheaper as compared to spending on credit cards.
The process is similar to taking any other loan. You can offer your bank a host of collaterals, such as your house, shares, bonds, insurance policies, fixed deposits and obtain such overdraft facility. But each one of these has their own upsides and downside.
For example, taking an overdraft against property though allows you a larger line of credit as compared to a fixed deposit in absolute terms, property evaluation will take some time. However, the bank will be much quicker while sanctioning overdraft against fixed deposits.
"Banks are more comfortable offering an overdraft against fixed deposits and traditional life insurance policies. Typically, traditional life insurance policies do not offer good returns. Taking an overdraft against them is a better way to putting them to productive use, he adds.
Banks consider surrender value of life insurance policies while offering overdraft. Rajiv Raj says there are banks who selectively offer temporary overdraft facilities against salary of an individual. For example, if you have a salary of Rs 1 lakh a month, there is a credit line of Rs 50,000 available to you, the salary credited is adjusted against the credit outstanding at the end of the month.
You have to also factor in the 'haircut' - the margin of safety - the bank will take. For example, the bank will be comfortable in approving limit up to 50% of the value of the property but in case of a fixed deposit, may offer up to 70% of the fixed deposit amount.
Depending upon the limit you need, you should choose the collateral. Along with the collateral, banks charge a small one time fee — 0.5 to 1%, subject to a cap of, say, Rs 25,000. This is especially true when you are offering property as collateral as the bank has to conduct due diligence on the title and value of the property. Overdraft limits are approved for a year, and the bank typically reviews them each year.
Financial experts say, overdraft facility is meant for disciplined individuals. This is because many people tend to misuse the funds. "It is a credit line available with you, and if you use it to fund speculative activities such as short-term trading in stocks, commodities or currencies, it may backfire.
If you lose in such speculative adventures, you have to pay for it in addition to the interest accrued on the overdraft availed. And if you fail to pay on time, the bank may liquidate the asset.