Are you constantly tight on cash? Need a lump sum for a big purchase? Cash liquidity is not always accessible, but banks offer a number of tools that provide quick access to cash, including different types of loans and overdrafts. If you’re wondering what the difference between them is, how they work, and how to choose the best option for your needs, then you’ve come to the right place. We’ll break down for you everything you need to know about loans and overdrafts.
What is a loan?
A loan is a fixed sum of money issued by a bank to a customer, usually to serve a predetermined purpose. All loans come with set terms, including tenor, fees, and interest rate. The tenor is the period over which the loan will be repaid by the customer, while the fees are what the bank charges for offering the service. As for the interest rate, it is a percentage the bank adds to the sum of the loan to make a profit. Interest rates vary from bank to bank, depending on both the type of loan and the Central Bank’s directives. The lower the interest rate, the better it is for the customer. When applying for a loan, the bank checks your financials, other loans, or credit cards, and decides the maximum amount, tenor, and interest rate based on that information.
Since loans are usually issued for a specific purpose, banks offer a variety of loans tailored for different goals. For example, an auto loan is used to buy a car, while an educational loan is used to pay for university tuition. If you need funds for purposes not covered by other loans, that’s where the personal loan comes in. Personal loans are also convenient when you need to borrow some money on short notice.
Interest rates and payment
Loan payments are made in the form of monthly installments on a fixed day of each month. The monthly installment is determined by the loan’s total sum, interest rate, and duration. You might have the option to decrease the repayment period and installment amount based on the bank’s policy and regulations. A loan’s interest rate is calculated based on the total sum borrowed (flat rate) or the remaining amount to be repaid (diminishing rate). A diminishing interest rate is calculated based on the outstanding loan amount every month, provided that you pay the bulk of the interest upfront, which also includes admin fees. This means that your first couple of payments are mainly to pay off the interest while later payments are to pay off the principal.
What is an overdraft?
While an overdraft is also a form of borrowing, it differs from a loan in that it does not entail a fixed amount of money. With an overdraft, you can withdraw more money than your current account balance up to a limit approved by the bank if needed. The bank determines the limit based on a number of factors, including your salary, account balance, repayment history, and credit score. An overdraft is a faster method of money borrowing and is better suited for short-term expenses of smaller sums, such as unexpected bills.
Interest rates and payment
Overdraft repayments are not linked to a fixed date and can be made any time through a lump sum or multiple deposits. Overdrafts also differ from loans in that their interest is calculated daily rather than monthly, meaning you are charged interest for every day the overdraft remains unpaid. An overdraft’s interest is also only charged on the amount overdrawn, while a loan’s interest is charged on the full amount borrowed, regardless of whether the whole amount was used. Typically, overdraft interest is higher than loan interest.
So how do I choose?
To decide whether you need a loan or an overdraft, you’ll first need to determine how much money you need to borrow, what you need it for, how soon you can repay it, and how much of it you can repay on a regular basis. You’ll also want to consider the various interest rates of each type of borrowing. Say you need to buy a car, then a loan would be your best choice, but if your electricity bill comes higher than expected, you should consider an overdraft. So, think of an overdraft as borrowed money that you can repay whenever you want (over a month even) and a loan as more of a long-term commitment with fixed repayment conditions.