What is the difference between overdraft and cash credit?

Both overdraft and cash credit can refer to a type of secured line of credit with a lender. These terms can also refer to the type of financial institution 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 demand deposit accounts.

Both overdraft and cash credit are really forms of borrowing. The institution allows you to withdraw funds that you do not have a demand claim to, usually in small amounts. The primary differences between these two 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 in hand, raw materials, or some other commodity. The credit limit extended on the cash credit account is normally a percentage of the value of the security offered.

Sometimes a financial institution offers a cash reserve account but calls it a cash credit instead. Cash reserves (sometimes called cash reserve credits) 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 individual demand deposit 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 your balance would normally permit. If you have $30 in a checking account, but you withdraw $35 to pay for an item, a bank that permits overdrafts spots you the $5 and typically charges you a fee for the service. You are generally charged a separate fee for every purchase in excess of your demand deposit balance.

Overdraft accounts, however, 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 even clean overdraft accounts, in which no specific collateral is offered; instead, clean overdrafts are granted against the worth of the individual. This is usually only possible when the borrower has a lot of funds parked at the financial institution and enjoys a long-standing relationship with the bank.

Overdraft Protection

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

Overdraft protection comes in several forms and might mean 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 very helpful in avoiding overdraft fees or having insufficient funds to execute a transaction.

Some overdraft protections do not link two accounts; instead, they simply allow for your demand deposit account to go into the negative, normally up to a predetermined limit. This service is costly, as every overdrawn transaction results in a hefty overdraft fee that is automatically charged against your account.

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

Overdraft Settings

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

Overdraft settings are found on most financial institutions' websites and briefly describe the treatment of overdrafted transactions. Sometimes, there are different overdraft settings for debit/credit card transactions than for written checks or cash withdrawals. As a customer, you may be given some discretion over how you would like to use overdraft protection on your account; you might, for example, decline the overdraft protection entirely if you want 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 their standard account settings normally allow for it. Accounts in good standing without a history of overdrafts are more likely to have overdrafted 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 simply stopped offering overdraft privileges or changed their overdraft setting options. To comply with regulations, you likely have to voluntarily agree to and sign up for overdraft protection on your accounts. The costs of these protections is disclosed to you, as are your options under the institution's overdraft settings. The specifics of these allowances can vary, so be aware of the policies at your own bank or credit union, and know what costs are associated with overdrawing on your account.