What Is a Draft in Banking and How Does It Work?
Gain a clear understanding of bank drafts. Learn their fundamental nature, secure function, and how they facilitate payments in banking.
A bank draft serves as a secure financial instrument, enabling individuals to make payments with a guarantee of funds. Unlike a personal check, its payment is assured by the issuing bank, making it a preferred option for transactions where the recipient requires certainty that the funds will be available.
Core Characteristics of a Bank Draft
A bank draft is distinct from a personal check because it is drawn on the bank’s own funds or its liability, rather than directly on a customer’s account. This fundamental difference means the bank itself guarantees the payment. When a bank issues a draft, it has already secured the necessary funds, either by withdrawing them from the customer’s account or by receiving them directly, such as in cash.
The guarantee of payment provided by the issuing bank makes bank drafts a highly secure method for financial transactions. This security is particularly valuable for large or significant payments, such as down payments on real estate or large equipment purchases. It offers peace of mind to the payee, knowing that the funds are assured upon presentation of the draft. Bank drafts also provide a clear, traceable record of the transaction, which can be important for financial accounting and in case of any future disputes.
Issuance and Processing of Bank Drafts
Obtaining a bank draft typically begins with a customer’s request to their financial institution. The customer specifies the desired amount and the name of the payee. The bank then verifies that the customer has sufficient funds to cover the draft amount, along with any applicable fees.
Upon confirmation of funds, the bank withdraws the specified amount from the customer’s account. The bank then issues a physical document, resembling a check, which includes details such as the issuing bank’s name, the payee’s name, the draft amount, and a unique serial number.
Once the payee receives the bank draft, they can deposit it into their own bank account. The clearing process for bank drafts is generally faster than for personal checks due to the bank’s guarantee of funds. While personal checks might take several days to clear, bank drafts often clear more quickly, sometimes within 24 hours to a few business days, though exact times can vary depending on the banks involved. Fees for issuing a bank draft can range from being free for certain accounts to typically up to $10.
Common Forms of Bank Drafts
The term “bank draft” can encompass several variations. One of the most widely recognized forms in the United States is the cashier’s check, which is a check issued by a bank and drawn on the bank’s own funds. While some sources use “bank draft” and “cashier’s check” interchangeably, a key distinction can be that a cashier’s check is drawn directly on the issuing bank’s funds, whereas a bank draft might be drawn by one bank on another bank or payable through a bank. Both, however, provide a guarantee of payment from the bank.
Another common type is a demand draft, which is a physical payment instrument issued by a bank that guarantees the availability of funds. Demand drafts are prepaid instruments, meaning the funds are debited from the purchaser’s account when the draft is issued. They are payable immediately upon presentation to the bank, and unlike personal checks, they do not require a signature to be cashed, though regulations exist to prevent fraudulent use. Demand drafts are often used for secure payments where cash or personal checks are not suitable, such as paying college fees or making large transfers.
In international trade, two specific types of drafts are encountered: sight drafts and time drafts. A sight draft requires immediate payment upon presentation to the drawee, typically an importer. The exporter provides the draft along with shipping documents, and the importer must pay the amount to receive the documents necessary to claim the goods. This mechanism provides security for the exporter, ensuring payment before the goods are released.
Conversely, a time draft allows for a delayed payment. It specifies a future date or a period after presentation when the payment becomes due, providing the importer with a grace period to pay for received goods, often after they have had a chance to sell them. This type of draft functions as a short-term credit arrangement, common in international transactions where the buyer needs time to manage cash flow.