Personal loan vs overdraft facility: What to choose between the two and how to? MintGenie explains

The choice between an overdraft facility and a personal loan depends on myriad situation-specific factors. An outline of the key factors is provided here.

Loan objective

• When you have prearranged expenses and know exactly how much money you'll need, personal loans are great. This could entail large purchases, debt consolidation, or home renovations.
• Overdrafts are more appropriate for unforeseen, transient needs like covering gaps in income, unplanned auto repairs, or unforeseen expenses.

Terms of repayment

• A personal loan provides more predictable repayment terms by requiring fixed monthly installments (EMIs) over a predetermined period (typically 1–5 years).
• An overdraft facility provides more flexibility by enabling any amount to be repaid over time as long as it stays within the credit limit. But there's a propensity to maintain a balance and pay interest on an ongoing basis.

Rates of interest

• You can see exactly how much interest you will be paying on your personal loan over its whole term because these loans typically have fixed interest rates that are less than those of overdraft accounts.
• Interest on an overdraft is often computed daily on the borrowed amount, which could lead to higher fees, especially if the borrowing period is longer.

Adaptability

• Personal loans typically have terms that must be fulfilled, and there might be fees associated with early repayment.
• Because the overdraft can be repaid in multiple installments rather than one large payment, overdrafts provide even more flexibility.

Impact on credit score

• If you have a poor credit history, you may be able to raise your credit score by managing your personal loan properly, which includes making on-time repayments.
• Frequently using an overdraft, particularly if it gets close to its limit, can lower your credit score.

Accessibility and records

• The application process for personal loans requires the submission of certain documents, and each time a new loan application is submitted, the process must start over.
• An overdraft facility, on the other hand, once approved lets you take out the available money without requiring a new application.

Borrowing limits

• Personal loans usually offer higher borrowing limits, making them appropriate for long-term, high-value purchases.
• Overdrafts, in comparison, typically have lower borrowing limits compared to personal loans.

Approval process

• Verification of income and employment status is often required for personal loans, along with a credit check. The approval process may take several days or even weeks.
• Usually available with a checking account; no application is needed separately. However, getting a higher overdraft limit might require building a good rapport with the bank.

In conclusion, there are benefits and drawbacks to both overdrafts and personal loans. Overdrafts provide flexibility and immediate access to funds, while personal loans are best for fixed borrowing with a set repayment period. Which of the two you choose will depend on your unique financial needs and preferences.

Frequently Asked Questions (FAQs)

Q. What exactly is an overdraft facility?

Up to a predetermined amount, an overdraft facility lets you take money out of your bank account even when it has no money in it. It serves as a short-term loan to pay for unforeseen expenses.

• Your savings or checking account can be connected to your overdraft facility.
• The maximum amount that can be taken out is represented by a credit limit that the bank sets.
• Up to this amount, you can withdraw money from your account using your debit card, checks, or online banking.
• Every day, interest is added to the amount borrowed.

Q. What advantages does an overdraft facility offer?

Numerous benefits that are advantageous to both individuals and organisations are provided by an overdraft facility. The principal advantages are as follows:

• Flexibility in cash flow management: An overdraft gives you greater freedom to control how much you spend each day and how you respond to changes in your cash flow by enabling you to borrow money up to a pre-established limit linked to your bank account.
• Easy access to extra funds: An overdraft, when connected to your current account, lets you swiftly take out a loan against the same account you use daily.
• Appropriate for short-term financial needs: It serves as a safety net and a source of backup funds, which is particularly helpful when handling short-term financial difficulties, unanticipated expenses, or emergencies.
• No collateral needed: Unlike certain loans, overdrafts don't require collateral, so you can apply for one without having to pledge assets like a car or house.

With interest rates typically applied only to the amount borrowed from the permitted limit, overdrafts can be a more affordable option for short-term borrowing than long-term loans.

Q. What are the disadvantages of an overdraft facility?

A facility known as an overdraft that permits people or businesses to take out more money than what is in their account has a number of drawbacks. The following are some of the primary drawbacks:

• Cost: Overdraft privileges may be expensive. It's an expensive option because the interest rate on the overdrawn amount is frequently higher than that of other borrowing options.
• Varying interest rates: It can be challenging to accurately predict borrowing costs due to the frequent fluctuations in overdraft interest rates. Over time, this fluctuation may lead to increased costs and uncertainty.
• Decreased unused facilities: Banks can abruptly cut back on unused overdraft credit, but this rarely happens unless an account holder is having serious financial problems. This cut could restrict the amount of money available and have an impact on cash flow management.
• Control by the issuing bank: The issuing bank has complete control over overdraft facilities. Without providing much notice, the bank has the authority to recall or cancel the overdraft, putting the account holder in a position where they are unable to pay their debts.
• Individuals or business owners may face personal liability if they fail to reimburse overdraft facility withdrawals. This personal duty may place further strain on the account holder and their assets.
• Possible liability: Overdraft facilities may prevent organisations from lowering bad debts, negotiating extended payment periods with suppliers, or improving cash flow. This can result in a reliance on the overdraft rather than addressing underlying financial concerns.

Q. How does one qualify for an overdraft facility?

To qualify for an overdraft facility, a few requirements need to be fulfilled. The key things to think about are as follows:

• A facility for an overdraft may be available to applicants who already have bank accounts.
• The bank sets the minimum term for an operational account. You need to have an active account for a certain period to be eligible for an overdraft facility.
• There is no minimum salary requirement for an overdraft facility, but your company must provide a monthly salary.
• The bank will start examining your application and running numerous background checks as soon as you apply for an overdraft account. They'll look into your capacity to pay back the loan balance.
• Overdraft facilities let you pay back the borrowed amount at any time; there are no monthly payments needed. You have the option to repay the amount in full or in part, depending on your preferences and financial situation.
• Depending on the overdraft facility, collateral may be required. While unsecured overdraft accounts might not, secured overdraft accounts might need collateral in the form of stock or other assets.

Q. What other options exist instead of an overdraft facility?

A type of short-term loan known as an overdraft facility is provided by banks and enables account holders to take out more money than is available in their account, subject to a cap. Overdrafts are convenient, but there are instances when they come with outrageous fees and interest rates. When searching for substitutes for an overdraft account, take into account the following:

• As an alternative to an overdraft facility, certain banks offer a line of credit known as Flexi Loan. Short-term cash flow gaps can be filled with this unsecured line of credit, which also lets you deposit money into your transaction account up to your credit limit.
• Merchant cash advances are available as short-term business financing options that enable entrepreneurs to borrow a predetermined sum of money from lenders. Fees are assessed as a percentage of future revenue and added to the amount borrowed when it is returned. This option offers more flexible access to finances and can be useful for business transactions.
• By selling their invoices or accounts receivable to a third party at a discount, companies can raise capital through invoice discounting and factoring. Quick cash flow can result from this while you wait for customer payments.
• Businesses can access a predetermined credit limit through revolving credit facilities, such as business credit cards or credit lines. These facilities provide businesses more flexibility in managing their cash flow by allowing them to borrow and repay funds as needed.