Business overdrafts: how they work and when to use one

A business overdraft is a line of credit on your business bank account that gives you more short-term cash flow than your business can fund from its own capital. The British Business Bank describes it as credit your bank provides when you need to withdraw more money than you have available.

Unlike a loan, which has fixed repayments and interest, an overdraft charges interest only on the amount by which you are overdrawn. You can pay it back as your cash flow allows, and you can ask the bank to increase or reduce your limit, which it must approve. You usually arrange it with your bank, online, by phone or in a branch, depending on the options your bank provides.

You agree a limit with your bank, and your account can then run below zero up to that limit. There is no separate drawdown: money leaves the account as usual and the overdrawn amount is the borrowing.

The table shows the arithmetic with round, made-up numbers. It is an illustration, not a typical limit or cost.

In the illustration, interest would apply only while the account was overdrawn, and only on the overdrawn amount. Your bank’s terms set how interest is calculated and charged, so read them.

A business overdraft costs interest on the amount you are overdrawn, plus any fees the bank charges. The British Business Bank says it is not free: you pay an annual interest rate on the overdrawn amount, and that rate varies between banks.

• Arrangement fee: for setting up the overdraft.
• Renewal fee: often charged each year when you renew the facility.
• Change fee: for changing, usually increasing, your limit.
• Unarranged overdraft fee: if you go over your limit.

The British Business Bank adds that overdraft rates are typically higher than for business loans and can change at any time, which is why an overdraft is generally considered a short-term solution. It also says your bank might charge a fee if you are late with a repayment or miss one, and that this can affect your credit report.

An arranged overdraft is agreed with your bank in advance up to a set limit, while an unarranged overdraft is any borrowing above that limit, or with no agreement at all. The British Business Bank lists an unarranged overdraft fee among the charges you may face if you go over your limit.

If you can see a payment approaching that would take you over your limit, talk to your bank before it happens rather than after, and ask what it would charge.

The main risks are that the bank can demand repayment, the cost is high for anything other than a short-term need, and charges and credit-report effects follow late or missed payments. The British Business Bank lists all three.

• Charges if you are late with a repayment or miss it altogether.
• Interest rates that are generally higher than business loans and can change at any time.
• A limit that you may need to renew, with a fee.

If the overdraft is a director’s way to fund a loss-making business for months, it is delaying a problem. Talk to your accountant.

Use an overdraft for short-term cash flow gaps you expect to close, such as waiting on a customer payment before payroll. It is the wrong tool for buying equipment, funding growth or covering a continuing shortfall.

Our guide to working capital explains why these gaps open, and a cash flow forecast shows you when to expect one.

Check the limit, how the interest rate is set and whether it can change, which fees apply, how often the facility is reviewed and whether the bank can demand repayment. These are the points the British Business Bank highlights, and the answers are in your bank’s terms.

• How big a limit you actually need. Use a forecast of your cash in and out rather than a round number.
• Whether there is an arrangement fee, a renewal fee or a fee to change the limit.
• What it costs if you go over the limit.
• Whether the bank can ask for the money back at any time, and on what notice.
• Whether you are asked for a personal guarantee, which would make you personally liable for the debt.

If you are a director, our guide to personal guarantees explains what signing one means.

An overdraft sits on your business bank account, while a business line of credit is a separate facility that lets you borrow up to an agreed amount when needed and pays the money into your account. The British Business Bank describes a line of credit as one that can revolve or have a fixed end date.

Our guide to revolving credit facilities compares the two in more detail, including costs and personal guarantees.

You can look at other lenders. The British Business Bank says that if your business has been unsuccessful in applying for finance from some of the UK’s major banks, the Bank Referral Scheme could help you find finance elsewhere, and participating banks must by law offer you a referral to another finance platform.

The Growth Guarantee Scheme also includes overdrafts among the products accredited lenders can offer. Facilities start at £25,001 for overdrafts and run from three months up to three years, but not all lenders offer all products and the lender decides. The borrower always remains 100% liable for the debt.

Capzy is a credit broker, not a lender, and is paid by the lender. An overdraft is an arrangement with your own bank, so that is where to ask first. If it does not fit, we can introduce you to lenders offering other kinds of finance.

You can check your funding options with a soft search that does not affect your credit score, or browse the lender directory. A full application to a lender may involve a hard search, and any offer is subject to status and lender criteria. Capzy does not give tax or accounting advice.