Last updated: 16/10/2020 | Estimated Reading Time: 5 minutes
Loans vs Overdrafts
It’s never been easier to borrow money, but borrowing the right way can be the difference between smart planning and financial trouble.
We take a look at overdrafts and loans, and round up the benefits and drawbacks of each.
In This Guide:
- What is an overdraft?
- What is a loan?
- How much can I borrow?
- How long does it take to get an overdraft or loan?
- Overdraft Advantages and Disadvantages
- Loan Advantages and Disadvantages
- Compare Loans and Overdrafts
What is an overdraft?
An overdraft is assigned by your bank to your current account. It allows you to continue borrowing money even when your balance reaches 0 so, essentially, you end up with a negative balance. But while in a negative balance, you’re still able to access and spend money up to an agreed limit. It’s often viewed as a short-term solution to borrowing money, as many banks charge monthly interest on overdrafts.
What is a loan?
A loan, on the other hand, is where you borrow a fixed amount that you have to pay back - it’s less flexible and more structured. Loans are generally paid off monthly, with added interest, over a much longer period – typically several years, with the minimum often being a year. So, they’re more of a long-term solution to borrowing money.
How much can I borrow?
How much money you need to borrow will determine whether a loan or overdraft is the right option for you.
Loans range between £1,000 to £25,000, with the best interest rates being offered for loans in the bracket between £7,500 and £15,000, according to research carried out by Which?. It’s worth remembering that these are personal loans – for larger sums you may need to consider taking out a homeowner loan.
By contrast, overdrafts generally have an upper limit of about £2,000. However, if you have a good credit score some banks may agree to extend this.
It’s worth knowing that some banks are looking towards offering small loans instead of overdrafts, and these could have lower interest rates than overdrafts. Watch this space.
How long does it take to get an overdraft or loan?
Overdrafts can be approved in as little as a few hours; loans within a day. However, it’s dependent on your credit score: if you’ve got a dubious history, it could well take longer to be approved.
Overdraft Advantages and Disadvantages
With overdrafts, you’re not obliged to borrow up to your limit. If you have an overdraft of £1,000 but are only in need of £500, then you can just borrow that £500. Plus, unlike loans, you’re able to pay off your overdraft at any point with one lump sum.
Some banks also offer interest-free overdrafts for certain demographics or time frames, such as to students; this can be a cheaper way to borrow money than taking out a loan.
Yet overdrafts do come with their own set of warnings. For one, you may not get such a cheap deal on interest, with some banks charging dear rates in comparison to loans. And on top of interest, you may well be charged penalty fees if you go beyond your agreed limit. These fees can hit both aggressively and repetitively, and it’s a tough cycle to break once you’re stuck in it.
Loan Advantages and Disadvantages
For loans, you pre-determine a sum you want to borrow: it’s fixed. As a result, loans typically offer more competitive rates of interest than overdrafts and consequently there are some cheap loans up for grabs out there. In most cases interest rates are fixed, so you can budget your repayments and save more money long term than with an overdraft.
However, be aware that interest rates are often high for small sums. Compare deals to see if you can get an agreed overdraft for how much you need to borrow, and check out the rates of interest offered.
Lenders profit on accrued interest, and your agreed plan is calculated to maximise that. Therefore, you’re obliged to pay back the full sum you borrowed on a set repayment plan, even if you don’t spend it. For example: you take out a loan for £5,000 for a new kitchen but, being the savvy person you are, spot a bargain and get it for £3,500 instead. Although you’ve not spent £1,500 of your loan, you must keep to the agreed monthly payments for a £5,000 loan. Some lenders may allow you to make early repayments, but you’ll be charged for doing so. Yep – it could cost you to be efficient.
Lastly, loans are categorised as unsecured or secured, and you want to be wary of secured loans. This means that one of your assets, such as your house or car, is used as collateral against you – i.e. if you don’t repay, then your property could be repossessed.
Compare Loans and Overdrafts
Ultimately, the only way to get the best deal when it comes to borrowing money is to do some research. Run a loan comparison with Money Expert, and then compare overdraft deals too. Your bank may not be able to provide you with an overdraft that works for you, but if another bank does then consider switching your accounts to reap the benefits. Loans don’t require this – you can just apply.