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Loan vs Overdraft

Loan vs Overdraft

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Last updated: 11 August 2021

There are a variety of different ways to borrow money, among the most common of which are personal loans and authorised overdrafts. Personal loans are suitable for people that are looking to borrow a large amount of money over a long period. Overdrafts are a short-term solution using your current account and will charge less interest if you pay the charges on time. This guide will compare loans and overdrafts to help you see which one you are better suited for, and also look at alternative solutions to your borrowing needs.

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What is a loan?

A loan is an agreement with a lender to borrow money for a set amount of time. They are set up so you have a fixed repayment schedule, usually monthly. Loans will often be given with a certain percentage of interest, meaning that you will end up paying more money back than you initially borrowed. They tend to be longer term than an overdraft and for larger sums of money. Loans can be ‘secured’ or ‘unsecured’. A secured loan means you use an asset such as your house as insurance for the bank in case you can’t pay it back. An unsecured loan means you don’t have to put anything as insurance but you will have to have a good credit history so the lender can trust giving the money to you.

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What is an overdraft?

An overdraft is a way of borrowing money through your bank using your current account. It will be limited and you will have to pay it back into the account within a certain time frame. Overdrafts typically have interest although there are certain cases where banks will give you a fee and interest free overdraft for a certain period of time. For instance, a student account will normally have a fee-free overdraft during and just after your studies. Generally, you have to request an overdraft although it may be given to you automatically when you open your bank account.

Advantages of a loan

  • A loan will allow you to borrow much more money than an overdraft, with a secured or homeowner loan allowing you to borrow the most amount of money.
  • If you are looking to borrow money long term, loans are the best option because they give you a longer time frame to pay them back.
  • Interest rates can be fixed so it’s easy to budget, with regularly monthly repayments that can be factored into your outgoings.

Disadvantages of a loan

  • If you take out a secured loan it will require you to link your highly valued assets to it, such as your car or property. This means that should you fail to make the repayments, your lender has the ability to repossess those assets.
  • If you are borrowing a smaller sum of money, the interest can be higher than if you were to set up an overdraft. With a loan you will also be paying interest on the interest you have paid.
  • Generally, there will be an early repayment fee, meaning that you can’t pay it back early without being charged, locking you into a long term loan.

Advantages of an overdraft

  • They don’t require anything to be put down as security.
  • There are no early repayment charges.
  • Good for short term borrowing, and relatively simple and straightforward to set up.
  • If you stay within the agreed limit, the fees can be manageable.

Disadvantages of an overdraft

  • Although they’re an effective and cheap way of borrowing short-term, overdraft charges can add up if you fail to pay it back on time and turn it into a long-term loan.
  • There is a limit on how much you can borrow and are therefore not a good way of borrowing large sums of money.
  • The bank has the ability to cancel your overdraft at any time, in which case you will be liable for the funds.

Are there any other alternatives?

The most common alternative people use is a credit card. Many credit card companies will offer deals such as 0% interest for a certain amount of borrowing for up to two years. If you were to get a 0% money transfer card you can move money into your current account and pay no interest if you pay it off in the time provided. Credit cards also provide more security if you are using the money to travel abroad.
The key disadvantage with a credit card is that the best deals are often reserved for those with a good to excellent credit score. If you have a poor record of paying back lenders, or are a young adult without much borrowing history, you are unlikely to get the sort of deals that make credit cards a more effective way of borrowing than an overdraft or loan.

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Fergus Cole

Author: Fergus Cole

Fergus is a journalist specialising in the personal finance, energy and broadband sectors. He also has a passion for travel and adventure so tries to make the most of this in any spare time he gets.

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