Business Overdraft Debt: When an Overdraft Becomes Long-Term Borrowing

What an overdraft is for, and how it is often used

A business overdraft lets the current account go below zero up to an agreed limit. It exists to cover timing differences: wages due on the 28th when the big customer pays on the 5th, or a VAT quarter that lands before the season starts. Used that way, the account swings in and out of credit and the business pays interest only on the days it is overdrawn.

In practice many businesses use the overdraft as permanent capital. The limit becomes the new zero. Stock is bought, a van is paid for, a slow quarter is absorbed, and the account settles into a pattern of hovering near the limit every month. This is what banks call hardcore borrowing: the part of the overdraft balance that is never repaid. It is a loan without a repayment plan, and because it is still labelled an overdraft, nobody has had to decide how it will ever be cleared.

What business overdraft debt costs

Overdraft interest is charged daily on the overdrawn balance, at a rate that is usually higher than a term loan from the same bank. On top of that, most banks charge an arrangement fee to set the facility up and a renewal fee each year it is reviewed, typically a percentage of the limit. Going beyond the agreed limit triggers unarranged overdraft charges, higher interest and often returned payment fees, and it damages the bank's view of the business.

For a short dip, these costs are modest. For a balance that sits at the limit all year, they are high. A business paying daily interest and an annual fee on £40,000 it never repays is often paying more than it would on a loan for the same amount, with none of the certainty. Our debt comparison tool can put the two side by side using your own figures.

Repayable on demand

The feature that makes an overdraft genuinely risky is in the small print. Almost every business overdraft is repayable on demand, which means the bank can ask for the full balance back at any time, whatever the reason. In practice banks rarely do this without warning, but they do reduce limits, decline renewals and impose tighter conditions, particularly when:

• the annual review shows the account has not returned to credit for months;
• accounts are filed late or show losses;
• the business is in a sector the bank has decided to reduce exposure to;
• there are returned payments, excess positions or other signs of strain.

A limit cut from £40,000 to £25,000 at renewal is a demand for £15,000 that the business has not planned for. Businesses that have treated the overdraft as permanent capital have no obvious way to meet it, and the result is often a scramble for expensive short-term finance.

Signs the overdraft has become a problem

• The account has not been in credit at any point in the last three months
• Payments are timed around the limit rather than around when they are due
• The limit has been increased more than once to relieve pressure
• Unarranged charges or returned payments appear on statements
• The bank has asked for forecasts, security or a personal guarantee at review

If several of these apply, the business has a borrowing requirement that an overdraft is not the right product for. It may also have a deeper cash flow problem that no facility will fix on its own.

Options for dealing with hardcore overdraft debt

Convert the hardcore element to a term loan

The cleanest fix is to separate the two jobs the overdraft is doing. The permanent balance, say £30,000 of a £40,000 limit, is repaid with a term loan over two to five years at a fixed monthly amount. The overdraft limit is then reduced to what the business actually needs for swings, and the account starts clearing again. Banks sometimes propose this themselves at review. Otherwise an unsecured business loan from another provider can do the same job, usually with a personal guarantee for a limited company. A longer term lowers the monthly cost but increases the total interest paid, so the term should match how long the business genuinely needs.

Invoice finance or a revolving facility

Where the overdraft is funding customers who pay slowly, invoice finance can be a better fit. The facility grows with sales rather than being fixed at a limit set years ago, and it is secured on the invoices rather than relying on the bank's goodwill. A working capital or revolving credit facility works like an overdraft but with a committed term, so it cannot be withdrawn on demand in the same way. Both carry fees and both need to be compared carefully against the overdraft they replace.

Consolidation

If the overdraft sits alongside cards, a merchant cash advance or several loans, it may make sense to deal with all of them at once through business debt consolidation. One fixed repayment replaces the collection of facilities, and the overdraft limit can be cut or closed. The usual cautions apply: fees, security, a personal guarantee and the risk of running the overdraft back up afterwards.

Negotiating with the bank

Banks would generally rather restructure than call in an overdraft. A business that approaches its relationship manager before the review, with a forecast and a proposal to convert part of the balance to a loan, is in a stronger position than one that waits for the letter. Bringing accounts up to date and explaining what caused the hardcore position both help. Finance Business Debt does not negotiate with banks on anyone's behalf, but we can explain the options that a business might raise.

Frequently asked questions