Differences Between Overdraft and Cash Credit

Both overdraft and cash credit refer to lines of credit with a lender. These terms can also refer to the type of bank accounts that allow you to withdraw more funds than you actually have on deposit – hence, the words "over" and "credit." Both are used to prevent checks from bouncing or debit cards from being declined when there are insufficient funds in checking accounts.

At the simplest level, overdraft and cash credit are just forms of borrowing. The institution allows you to withdraw funds that you do not have, usually in small amounts. The primary differences between these forms of borrowing is how they are secured and whether the money is lent out of a separate account.

Cash Credits

Cash credits are more commonly offered for businesses than individuals. They require that a security be offered up as collateral on the account in exchange for cash. This security can be a tangible asset, such as stock, raw materials or another commodity. The credit limit extended on the cash credit account is normally a percentage of the value of the collateralized security.

Sometimes a financial institution offers a cash reserve account but calls it a cash credit. Cash reserves are unsecured lines of credit that act like overdraft protection. They typically offer higher overdraft limits and have smaller real interest costs on borrowed funds than overdrafts, since penalty fees are not triggered for using the account.

It is common for cash credits to be renewed annually for a business line. However, an account holder's access to overdraft protection is reviewed annually and may or may not be re-approved by the bank.

Overdrafts

There are several different types of overdrafts but the two most common are standard overdrafts on checking accounts and secured overdraft accounts that loan cash against various financial instruments.

A standard overdraft is the act of withdrawing more funds from an account than the balance would normally permit. If you have $30 in a checking account and withdraw $35 to pay for an item, a bank that permits overdrafts covers the $5 and typically charges you a fee for the service. You are generally charged a separate fee for each purchase in excess of your account balance.

Secured overdrafts act more like a traditional loan. As with a cash credit account, money is lent by a financial institution but a wider range of collateral can be used to secure the credit. For example, you might be allowed to use mutual fund shares, LIC policies or even debentures. There are also clean overdraft accounts, in which no specific collateral is offered but overdrafts are permitted due to the net worth of the individual. Generally speaking, this is only possible when the borrower has a large account at the financial institution and enjoys a long-standing relationship.

Overdraft Protection

The process of granting short-term credit to an account holder when his or her balance reaches zero is known as overdraft protection.

Overdraft protection comes in several forms and means different things for different banking relationships. It is common for overdraft protection to link two accounts together, allowing funds to automatically be drawn on a reserve account in the event of the primary account being drawn to zero. This function can be helpful in avoiding overdraft fees or having insufficient funds to execute a transaction.

Some overdraft protections do not link two accounts. Instead, the bank allows the checking account to go into the red, up to a predetermined limit. This service is costly, as each overdrawn transaction incurs a hefty overdraft fee that is automatically charged against the account. See How Overdraft Fees Work and How to Avoid Them.

Overdraft protection can also be sold as a separate unsecured line of credit tied to the primary account, acting as an emergency loan in the event of an overdraft. These types of overdraft protections do not have overdraft fees but charge interest on the credit line balance.

Overdraft Settings

Overdraft settings are the guidelines for how a given financial institution offers and executes overdraft protection on specific checking accounts. Simply stated, overdraft settings govern overdraft protection.

Overdraft settings are found on most financial institutions' websites and briefly describe the treatment of overdraft transactions. Sometimes, there are different overdraft settings for debit/credit card transactions than for checks or cash withdrawals. As a customer, you choose how to use overdraft protection on your account and can opt out entirely to prevent your account from holding a negative balance. Check with your banking institution to understand how overdrafts are treated for your specific accounts.

Overdraft settings are not universal. Most financial institutions reserve the right to refuse extending credit on certain transactions or for certain customers, even if standard account settings allow for it. Accounts in good standing without a history of overdrafts are more likely to have overdraft transactions approved. The use of overdraft features has become increasingly regulated and scrutinized, especially as it relates to charging overdraft fees. As a result, some institutions have stopped offering overdraft privileges entirely or have narrowed overdraft setting options.

To comply with regulations, the customer needs to voluntarily agree to and sign up for overdraft protection. The costs for this service are disclosed, as are conditions of the institution's overdraft settings. The specifics can vary, so be aware of the policies at your own bank or credit union, and know what costs are associated with overdrawing your accounts. For details, see Bank Overdraft Regulations: What You Need to Know.