What are the main differences between an overdraft vs a personal loan? Our guide helps you find the best solution for your personal circumstances. As both loans and overdrafts are forms of debt, it’s important to remember to keep on top of your finances to avoid getting deeper in debt.
What is an overdraft?
An overdraft refers to the agreed borrowing of money once your bank account is empty. In effect, an overdraft is a type of loan and is a form of debt. This means you will have to repay the amount owed to the bank along with interest.
There are two types of overdraft:
- Authorised – This type of overdraft is arranged in advance. This agreement is also known as an ‘arranged’ overdraft. It allows you to draw out and spend money up to a pre-agreed limit. You will need to arrange exactly how your overdraft works with your bank in advance of going into your overdraft.
- Unauthorised – You can be granted an unauthorised, or unarranged, overdraft when you spend more money than you have in your account. An unauthorised overdraft can occur even if you have a pre-arranged agreement with your bank but spend beyond your overdraft.
As of April 2020, banks are no longer allowed to charge higher fees for unauthorised overdrafts. The interest on your overdraft will be calculated as a single annual interest rate (APR). This makes it easier to compare charges between accounts.
Who is an overdraft suitable for?
As an overdraft is a form of debt, it’s wise to avoid it where possible. Overdrafts are best suited to emergencies and short-term borrowing. For example, an overdraft could be used to pay for unexpected costs such as a bill for home or car repairs.
Authorised overdrafts offer some advantages over a standard loan.
- Arranging an overdraft can be quick – Speak with your bank or manage your account online to set this up. You can then just withdraw cash with your debit card as usual.
- Minimal impact on your credit score – Provided that you do not exceed your overdraft limit or default on payments, having an authorised overdraft can help improve your credit score.
- Useful for short-term borrowing and one-off expenses – An overdraft can offer better rates and more flexibility if you need to cover for one-off expenses such as an emergency.
- Flexibility – You can increase, decrease or cancel your overdraft at any time. Remember, you will still have to repay any money owed before cancelling.
As with all forms of debt, it’s important to consider the disadvantages.
- An overdraft can only be arranged with your bank – If you have a current account, you can only arrange an overdraft for this account with your bank directly.
- Lower borrowing limits – Overdrafts offer much lower borrowing limits in comparison to loans.
- Higher interest rates – The interest rates for overdrafts are often higher than those of a loan and are usually at a variable rate.
- Exceeding your overdraft – You may be charged or suffer an increased interest rate if you spend more than your overdraft limit allows. Spending beyond your overdraft limit can also negatively impact your credit score.
- An overdraft can be cancelled or limited at any time – Unlike a loan, an overdraft can be revised by the bank at any point.
What is a loan?
A loan is an agreed transfer of money between a lender and a borrower. The borrower must also agree to pay off the loan over a pre-agreed length of time. This could be used to cover a big purchase or help access the funds to pay off or consolidate other debt.
The two most common types of loan are unsecured and secured loans.
With a secured loan, the borrowed money is secured against an asset such as your home. In this case, failure to make repayments may result in the repossession of your home.
An unsecured loan, or personal loan, is not secured against any assets. The amount you can borrow and the interest rates are determined based on your credit score.
There are some key differences between overdrafts and loans.
- Higher borrowing limits – Loans have higher borrowing limits and lower interest in comparison to overdrafts. This makes them handy for long-term borrowing.
- Fixed repayments – You will agree on a fixed payment plan when finalising your loan application. This makes it easier to keep track of your finances and budget for monthly repayments.
- Fixed interest rates – Unlike overdrafts, loans offer fixed interest rates. This can be more sustainable in the case of long-term borrowing.
- Could help improve your credit score – Your credit score could increase over time if you keep up with regular repayments.
Although loans can be a good solution for long-term borrowing, there are some disadvantages to consider.
- Less flexibility – You will need to stick to your agreed payment terms. Failure to do so will impact your credit score.
- Risk of secured loans – You could risk losing your home if you have chosen a secured loan against your house.
- Early repayment charges – Unlike an overdraft, there may be further charges if you pay your loan off early.
- Secured loans have a lengthy application process – It may take a week or more to apply and finalise your application for a secured loan.
What alternatives are there?
An overdraft or loan might not be the best fit, depending on your personal requirements. Credit cards can be useful for those looking to spread the cost of a purchase. Consider a 0% purchase credit card for this sort of spending. Meanwhile, a 0% balance transfer credit card could help you consolidate existing debt.
Credit cards do have some downsides. Compared to a loan, credit cards often do not allow for borrowing of higher sums of money. Also consider that your deal for a 0% credit card could come to an end. This may result in high interest rates and adjustments to your monthly budget.
Look no further than our Know How section for more financial advice and information on loans.