Cash Credit vs. Overdraft: What's the Difference?

Cash credit and overdraft both refer to lines of credit with a lender. These terms also can refer to the types of bank accounts that allow you to withdraw more funds than you actually have on deposit—hence, the words "credit" and "over." 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, cash credit and overdraft are just forms of borrowing. An institution allows you to withdraw funds that you do not have, usually in small amounts. 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 small negative balance without incurring a large overdraft fee.

Cash credit is more commonly offered to businesses than individuals. It requires 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. A cash reserve is an unsecured line of credit that acts like overdraft protection. It typically offers higher overdraft limits and has smaller real interest costs on borrowed funds than an overdraft, since penalty fees are not triggered for using the account.

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

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. You generally are charged a separate fee for each purchase in excess of your account balance, though different institutions may handle their fees differently.

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. For example, you might be allowed to use mutual fund shares, LIC policies, or even debentures. There also is a clean overdraft account, 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 enjoys a long-standing relationship.

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

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.

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 does not have overdraft fees but charges interest on the credit line balance.

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.