Common in the banking industry, the words overdraft and loan make one of the most confusing pairs of words. Notably, both of the words involve borrowing cash from a financial institution.
However, the terms and conditions of borrowing some extra cash from a financial institution lead to differences between an overdraft and a loan.
Overdraft vs Loan
The main difference between Overdraft and Loan is that Overdraft is a credit given on a current account with a fixed credit limit. Loan is a fixed amount borrowed from the bank for a fixed time. In overdraft, withdrawal amount can vary with requirements, the loan amount is fixed and is repaid with interest.
Comparison Table Between Overdraft and Loan
| Parameter of Comparison | Overdraft | Loan |
| Purpose | For day to day business operations. For example, paying wages, paying debtors, and paying bills. | For the facilitation of long-term capital purchases. For example, asset purchases, setting up businesses, and system upgrades. |
| Security Requirements | Requires no security or collateral for acquisition. | Requires security or collateral for acquisition. |
| Repayment | Interest rates are higher compared to loans. | Interest rates are lower compared to overdrafts. |
| Time Duration | Offered for a few days to six months | It is offered for a longer period. The duration can reach up to twenty years. |
| Process of Acquisition | No internal process is required. | An internal process is required. |
What is Overdraft?
A bank overdraft refers to some credit facility where a current bank account holder is entitled to withdraw excess money than their current bank account amount.
An overdraft can be viewed as a short term loan where a current bank account holder is entitled to during withdrawal if the need arises.
The limit at which an overdraft can be made is agreed upon between the bank and the account holder. However, the bank has all the rights to alter the limit of your overdraft.
What is a Loan?
On the other hand, a loan refers to borrowed capital that a financial institution lends to either an individual or an organization for some specific purpose, having the amount repaid over time.
Notably, a bank loan is a long-term liability on a business balance sheet. On an individual level, a loan might be short-term or long-term based on the period of payment it is scheduled to take.
Main Differences Between an Overdraft and a Loan
Purpose
A bank overdraft is a facility that extended to current bank account holders to finance their day to day business operations. Through a bank overdraft, individuals and businesses can cover emergency expenses, pay wages to workers, issue payment to late debtors, and bill payments. On the other hand, a loan is offered to an individual or a business that needs loads of cash for a long-term specific purpose.
A loan is defined as borrowed capital to facilitate capital purchases. They include purchases on assets for a business or individuals, setting up a business, or even systems upgrade. Notably, loans cannot be obtained to cover payrolls, unlike overdrafts.
Security Requirements
While seeking a bank overdraft, no security or collateral is required to be availed by a current bank account holder. However, an individual or a bank must have a current bank account with the bank they are seeking an overdraft.
Unlike giving out an overdraft, a bank always requires security or collateral against the loan. Notably, companies can borrow loans from whichever bank or financial institution they knock at their doors. This is regardless of having a current bank account with the bank or not.
Repayment
The repayment of a loan is made through regular monthly installments. The interest is calculated from the product of the principal amount, the interest rate, and the duration in which the loan is to be paid.
The individual or company already knows the amount expected to pay for every month from dividing the total payable amount by the stipulated duration of payment.
On the other side, overdrafts repayment are different from those of a loan. Repayment of an overdraft is made when the company or individual has the convenience of additional money.
Notably, the interest rates of an overdraft are higher than those of the loans.
Time Duration
Overdrafts are given to individuals and companies to settle day to day expenses. The overdraft facility is used for short-term borrowing, where repayment is made between a few days to six months. On the other side, loans have a time duration longer than that of overdrafts. Loans might take up to twenty years to be repaid.
Process of Acquisition
To acquire a loan from a financial institution, an individual or company goes through an internal process that involves the recognition of the need. This follows the fact that loan liability is huge and takes a longer period of repayment. On the other side, the acquisition of an overdraft requires no internal planning process. So long as an individual or company is entitled to an overdraft, they can make it so long as it exceeds not the limit.
Frequently Asked Questions (FAQ) About Overdraft and Loan
Which is better Loan or Overdraft?
An Overdraft is an amount you borrow against your bank account in the form of withdrawals for meeting certain expenses.
The interest rate charged on the overdraft is comparatively less than the interest charged on a loan.
Overdraft is more feasible if the amount of money involved is a small sum compared to the minimum loan amount. But if you are in need of a bigger sum then a loan would be more feasible.
Does an Overdraft affect getting a loan?
Overdraft on your bank account doesn’t immediately affect your eligibility to get a loan.
However, every bank sets a due date with which the overdraft amount should be paid back by the account holder.
The bank authorities also inform the customer about this date but if the payment is delayed and the overdraft amount is sent to collections the bank authorities may curtail services like granting loans.
What is the disadvantage of an Overdraft?
Overdrafts have a fixed limit and are generally based on the type of account you hold and the rules of the bank. In other words, if you want a bigger sum an overdraft may not be able to help.
Also, overdrafts are subject to high-interest rates compared to loans.
Another disadvantage is that the time period of repayment is quite short in the case of overdrafts compared to personal loans.
How do you pay back an Overdraft?
Overdraft is paid back when your bank account is credited with the money.
For instance, if it is a salary account when the salary is credited the bank automatically deducts the overdraft amount.
If you are unable to clear your overdraft you can get a personal loan at a lower interest rate to repay the overdraft.
This is a feasible option because charges on an overdraft are higher and the time limit for repaying is shorter compared to loans.
Is Overdraft better than Credit Card?
Borrowing money using a credit card can cost you more because if you are not able to repay the amount within the grace period the interest rates charged are unusually high.
But in the case of overdrafts, the interest charged remains fixed.
However, if only a small amount is required for a short period of time using a credit card is an easier option.
Conclusion
From the above analysis, the difference between an overdraft and a loan is visibly evident. While an overdraft refers to a facility where withdrawal of funds can be made below a zero balance, a loan refers to funds borrowed against some collateral.
With knowledge about the difference between the two terms, one can approach the bank and obtain the optimal funding solution for their needs.
References
- https://www.econstor.eu/bitstream/10419/60770/1/622767518.pdf
- https://www.law.gmu.edu/assets/files/publications/working_papers/1366.pdf