Overdraft

An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation the account is said to be "overdrawn". If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit, then interest is normally charged at the agreed rate. If the negative balance exceeds the agreed terms, then additional fees may be charged and higher interest rates may apply.

The first overdraft facility was set up in 1728 by the Royal Bank of Scotland. The merchant William Hog was having problems in balancing his books and was able to come to an agreement with the newly established bank that allowed him to withdraw money from his empty account to pay his debts before he received his payments. He was thus the first recipient of cash credit from a bank in the world. Within decades, the advantages of this system, both for customers and banks, became apparent, and banks across the United Kingdom adopted this innovation into service.

With the onset of industrialization, new businesses needed an easy form of credit to jump-start their activities, without having to take out loans on securities they didn't necessarily have. The importance of this new financial innovation was recognized by the philosopher David Hume who described it in one of his essays as 'one of the most ingenious ideas that has been executed in commerce'.

Overdrafts occur for a variety of reasons. These may include:

Banks in the UK often offer a basic overdraft facility, subject to a pre-arranged limit (known as an authorized overdraft limit). However, whether this is offered free of interest, subject to an average monthly balance figure or at the bank's overdraft lending rate varies from bank to bank and may differ according to the account product held.

When a customer exceeds their authorized overdraft limit, they become overdrawn without authorization, which often results in the customer being charged one or more fees, together with a higher rate of lending on the amount by which they have exceeded their authorized overdraft limit. The fees charged by banks can vary. A customer may also incur a fee if they present an item which their issuing bank declines for reason of insufficient funds, that is, the bank elects not to permit the customer to go into unauthorized overdraft. Again, the level and nature of such fees varies widely between banks. Usually, the bank sends out a letter informing the customer of the charge and requesting that the account be operated within its limits from that point onwards. In a BBC Whistleblower programme on the practice, it was noted that the actual cost of an unauthorised overdraft to the bank was less than two pounds.

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Wikipedia