Cash credit and overdraft are two types of short-term financing that financial institutions provide to their customers. Both are used to prevent checks from bouncing or debit cards from being declined when there are insufficient funds in checking accounts. The primary difference between these forms of borrowing is how they are secured.

Business accounts are more likely to receive cash credit, and it typically requires collateral in some form. Overdrafts, on the other hand, allow account holders to have a negative balance without incurring a large overdraft fee.

How Cash Credit Works

Cash credit is commonly offered to businesses rather than to individual consumers. Financial institutions, such as banks and credit unions, normally require a business customer to put down a form of security as collateral in exchange for cash. This security can be a tangible asset, such as stock or property. The credit limit extended on the cash credit account is normally a percentage of the value of the collateralized security.

As mentioned, cash credit is a short-term financing solution a business customer has at their disposal. If the customer doesn't have enough funds in their account, they can use the cash credit for routine banking transactions up to the credit limit. Unlike other credit products, interest is charged on the daily closing balance.

Cash credit may also be referred to as a cash reserve account. A cash reserve is an unsecured line of credit that acts just like overdraft protection (see more below). It typically offers higher overdraft limits and has smaller real interest costs on borrowed funds than an overdraft because penalty fees aren't triggered for using the account.

How an Overdraft Works

Overdraft is a form of financing issued by a financial institution to individuals and is attached to a bank account—usually a checking account. If a customer doesn't have enough funds in their account to complete a transaction, the overdraft covers the difference, allowing the account to go into a negative balance.

Say you have $500 in his account and you write a $550 check. If you enrolled in overdraft protection, the bank may allow you to overdraw your account to cover the check, thus rendering you balance as -$50.

Overdraft protection comes in several forms and functions differently, depending on the banking relationship. 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 below zero. This function can be helpful in avoiding overdraft fees or having insufficient funds to execute a transaction.

Banks charge you a fee—sometimes as high as $38.50—per overdraft plus interest on the balance of you don't have overdraft protection on.

Overdraft protection also can 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. This type of overdraft protection doesn't have overdraft fees but charges interest on the credit line balance.

Types of Overdrafts

The two of the most common types of overdrafts are standard overdraft on a checking account and a secured overdraft account that lends cash against various financial instruments.

Standard Overdraft

A standard overdraft is the act of withdrawing more funds from an account than the balance normally would 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 small fee for the service, as opposed to a much larger overdraft penalty. Customers are generally charged a separate fee for each transaction in excess of their account balance, though different institutions may handle fees differently.

Secured Overdraft

A secured overdraft acts 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. Customers may, for example, be allowed to use mutual fund or stock shares.

Clean Overdraft

A clean overdraft account in one in which no specific collateral is offered, but an overdraft is 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 has had a longstanding relationship.

How To Set Up Cash Credit and Overdraft Protection

Business customers that can provide some form of collateral may be easily able to get access to cash credit, which means they won't have any liquidity problems in the event they need capital in a hurry. In most cases, cash credits are commonly renewed on an annual basis for business customers. This means businesses don't need to re-apply for credit.

Interest payments made on cash credit are tax-deductible, which means businesses can use them to lower their tax burden and save more money in the long run.

If a customer wants to add overdraft protection on their account, they must apply for the service just as they would for any other credit facility. The bank reviews the application and approval is subject to the customer's creditworthiness. Banks normally review whether to continue extending overdraft protection to a customer on a regular basis. Unlike cash credit, customers can't claim interest paid on overdraft protection for a tax deduction.

The Bottom Line

Cash credit and overdraft are types of short-term financing that financial institutions provide to their customers. Both are used to prevent checks from bouncing or debit cards from being declined when there are insufficient funds in checking accounts. The primary difference between these forms of borrowing is how they are secured. Business accounts are more likely to be given cash credit, which typically requires collateral. With overdrafts, banks allow account holders to briefly have a negative balance without incurring a large overdraft fee.