What is Drop Line Overdraft?

A Drop Line Overdraft is a specialized form of overdraft facility that allows borrowers to withdraw funds from their current account up to a pre-approved limit, with the unique feature that the overdraft limit gradually reduces (or “drops”) over time. This type of facility is typically used by businesses and individuals who need short-term funding but prefer a structured repayment plan that decreases over a defined period.

In a drop line overdraft facility, the borrower is allowed to overdraw up to a certain amount, and the repayment is typically made in installments. However, unlike a traditional overdraft where the limit remains static, the maximum amount available to the borrower reduces at regular intervals, eventually reaching zero by the end of the facility’s tenure.

Key Features of Drop Line Overdraft

1. Reducing Overdraft Limit:
   • In a drop line overdraft, the limit decreases progressively over the loan period. For example, if the total limit is ₹10,00,000 and the tenure is 12 months, the limit might reduce by ₹83,333 each month.
2. Short-Term Financing:
   • This facility is usually offered for short to medium-term financial needs, such as working capital requirements, inventory purchases, or cash flow management for businesses.
3. Interest on Utilized Amount:
   • Interest is charged only on the amount that the borrower actually uses, not on the total limit sanctioned. This makes it more cost-effective than a term loan, as interest is payable only on the outstanding balance.
4. Flexible Repayment:
   • The borrower has the flexibility to repay the overdraft amount as and when they can, within the reducing limit structure. However, as the limit decreases, the borrower must ensure that their outstanding balance is below the new limit.
5. Tenure:
   • The tenure of a drop line overdraft is typically shorter compared to traditional term loans and can range from a few months to a few years.

How Drop Line Overdraft Works

To illustrate how a drop line overdraft works, consider the following example:

• A business is approved for a drop line overdraft of ₹12,00,000 for a tenure of 12 months.
• The overdraft limit reduces by ₹1,00,000 each month.
• In the first month, the borrower can withdraw up to ₹12,00,000. By the second month, the maximum overdraft limit reduces to ₹11,00,000, and by the third month, it drops to ₹10,00,000, and so on, until the limit reaches zero at the end of the tenure.
• Interest is charged only on the amount that the borrower actually uses, and repayments can be made at any time, provided the outstanding balance remains within the reducing limit.

Advantages of Drop Line Overdraft

1. Cost-Effective:
   • Interest is only charged on the utilized portion of the overdraft, making it more economical for businesses that may not need to use the entire limit at once.
2. Structured Repayment:
   • The reducing limit forces disciplined repayments, which helps businesses gradually reduce their debt obligations while maintaining cash flow for operations.
3. Flexible Funding:
   • Unlike a term loan with fixed EMIs, a drop line overdraft offers the flexibility to withdraw and repay funds as per business needs, provided the balance remains within the decreasing limit.
4. Short-Term Liquidity:
   • It provides quick access to working capital, which is especially beneficial for businesses with seasonal or fluctuating cash flow needs.

Disadvantages of Drop Line Overdraft

1. Decreasing Limit:
   • The main disadvantage of this facility is the reducing limit. As the overdraft limit drops every month, the borrower’s access to funds decreases, which can be challenging if the business needs more funds later in the tenure.
2. Higher Interest Rates:
   • While interest is charged only on the utilized amount, overdrafts generally come with higher interest rates than term loans, which can increase the cost of borrowing in the long run.
3. Risk of Overdrawing:
   • As the limit reduces, borrowers must carefully manage their overdraft to ensure that they do not exceed the allowed limit, which can result in penalties or additional charges.

When to Use Drop Line Overdraft

A drop line overdraft is an ideal financing option for businesses that:

• Need short-term working capital but want the flexibility to borrow and repay as needed.
• Expect their funding needs to reduce over time, making a reducing credit limit suitable.
• Have seasonal cash flow requirements and need immediate liquidity without long-term debt commitments.