You may have heard a friend or family member say that they have entered their overdraft after spending a large amount of money, with this being a very common method nowadays of borrowing a certain amount of money, however this does mean that they can often be mistaken for a loan.
Both do share similar purposes and functions, however there are some important differences that anyone thinking of setting up an overdraft needs to know about so that they can be sure they’re making the right decision.
Here is a full breakdown we have put together below of how overdrafts work and if they are classed as a loan, along with any differences and similarities between the two.
How Do Overdrafts Work?
An overdraft is a variable amount of money that a bank has agreed to lend you for up to a set limit. This will allow you to borrow money through your current account by taking out more money than you actually have.
You can ask your bank to set up an overdraft for your account, however many people will have one automatically depending on the type of bank they are partnered with since some use them more often than others.
2 Types Of Overdrafts
There are 2 primary types of overdrafts depending on how much notice you give beforehand. These are:
- Authorised Overdrafts – An overdraft that has been arranged with the bank in advance where you can agree on the limit to the amount you can borrow and spend.
- Unauthorised Overdrafts – Also commonly referred to as ‘unarranged’ overdrafts, this includes either dropping into an overdraft without notifying the bank, or going over the agreed limit which can affect your credit rating and make it a lot harder to get a loan in the future.
Is An Overdraft The Same As A Loan?
Because you will be required to pay back the amount you borrow in an overdraft, it is therefore technically classed as a type of loan, however, they should not be mistaken with personal loans, which are the most popular type of loans that people will take out.
There are a few differences between the two, with the major one being that while you can pay back an overdraft how and when you like, loans have fixed terms and repayment schedules, making them less flexible than an overdraft.
In this sense, while the payments are flexible with an overdraft with there being no repayment term, a standard loan will need to be paid over monthly instalments across the agreed period.
Additionally, you can also often borrow a lot more when taking out a loan as opposed to an overdraft which is more-so set up to provide a person with the means of buying what they need there and then such as operating expenses and equipment purchases.
While an overdraft usually allows you to borrow between £500 and £2,000, with a secured loan you will be able to borrow up to £25,000 or even more in some cases, making it far more ideal for different situations.
Should You Choose An Overdraft Or A Loan?
The key factor that should determine whether you take out a loan or set up an overdraft is how you intend to spend the money and when exactly you need it. If this is for the short term where you feel like a safety net would be useful for your current situation where you might be spending a lot on living expenses, food, school and other necessities, then an overdraft is a much better way to go.
Loans on the other hand are much more suitable for long-term spending such as for an ambitious project or financing a special occasion such as a wedding that you need to prepare for.
You should also always keep in mind how much you know you will be able to pay back on time since if you know that you may not be able to have the money to pay in the monthly installments right away, an overdraft would be the better option since they are much more flexible, however if you’re someone who is good at budgeting and know you can pay back the money in small installments, you will probably prefer the more structured repayment scheme of a personal loan.
Finally, it is always worth checking the interest rates of an overdraft if you are thinking about setting one up since these can end up being incredibly high, making it a very expensive way to borrow money, so seeking out an interest-free overdraft is always worth it.
Pros And Cons Of Overdrafts And Loans
Here are a few of the biggest pros and cons of using an overdraft or a loan to help you decide which would be the best for your current situation.
Overdraft Pros
- Flexible repayment
- No fixed repayment term, pay back as and when you wish
- You can increase or cancel your overdraft at any time
- Great for short-period investments
Overdraft Cons
- High interest rates can make borrowing very expensive in the long term
- Easy to remain in an overdraft because there is no repayment term
- Less money to borrow than a loan
- Risk of the bank reducing the overdraft limit at any time
Personal Loan Pros
- Big lump sums of money in one instalment
- Monthly repayments make budgeting easier
- Easy way to grow a business or fund a long-term event or project
- Access funds immediately
Personal Loan Cons
- Can result in unnecessary debt
- Non-flexible repayment schedule means missing payments can damage credit report
- Larger loans will have certain terms and conditions that must be adhered to
- Interest rates can be very high for sums of $7,000 or more
Summary
While an overdraft can be classed as a type of loan since you are still borrowing a fixed amount of money from your bank, they are very different to personal loans which allow a person to borrow much more money and are more intended for long-term ventures rather than for the short term like an overdraft is.