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Should you get an overdraft or a loan?

Whether you should get an overdraft or a loan depends on your individual requirements. Overdrafts are credit facilities on current accounts, designed for short-term borrowing for a flexible amount. Whereas loans are for fixed amounts, usually for larger sums, to be repaid in agreed monthly instalments over the loan term.

5 min read
loan or overdraft

What is an overdraft?

An overdraft is the credit facility on your current account for when it goes into a negative balance. There are two types of overdrafts. ‘authorised’ (arranged) overdrafts have an agreed limit. If you go over this limit, you are using an ‘unauthorised’ (unarranged) overdraft which could lead to penalties and reduce your credit score.

Sometimes an authorised overdraft comes as an automatic feature on your bank account, or you might have to ask your bank to add it on.

Benefits of an overdraft

There are a number of benefits of using overdrafts as a form of credit. They’re useful for borrowing small amounts in the short-term (for emergencies for example). You can usually borrow up to around £2,000 (depending on the lender’s criteria and your circumstances).

Also, an overdraft is a very convenient form of credit. Since it’s attached to your bank account you can simply withdraw cash using your debit card. And you can get an overdraft approved within a few hours by your bank.

Overdrafts are very flexible. The money is available as and when you need it. There are no fixed repayments, so you can pay it back on an ad-hoc basis when you can afford to.

Disadvantages of an overdraft

There are some drawbacks to overdrafts which you also need to be aware of. For example, if your wages are paid into your overdraft account, these funds will be used towards your outstanding balance. So if you’re not careful, you could find yourself in a cycle where your wages are being absorbed each month.

Also, if you go beyond your arranged overdraft limit, you’ll be going into you unarranged overdraft, which could affect your credit score and your ability to get credit in the future. If you go into your unarranged overdraft you may face more interest and charges.

From April 2020, the FCA will stop banks and building societies from charging more for unarranged overdrafts than for arranged ones. Just be aware that some banks have announced that they are increasing authorised overdraft charges (to around 40% in some cases) to match unauthorised charges. So it’s best to keep an eye on any changes to your bank account, in case there’s a cheaper deal elsewhere.

What is a loan?

A loan is a lump sum that you repay in fixed monthly instalments, over a set period of time. There are two main types of loans: personal (unsecured) loans and homeowner (secured) loans.

Secured loans generally have better interest rates, but they are tied to your property, so you need to be a homeowner. Personal loans aren’t secured to anything but yourself, so they tend to come with higher interest rates to balance out the risk. Both types of loans can be used for almost any purpose (as long as it’s not gambling or anything illegal).

Bear in mind that with secured loans being tied to your property, it means that your home could be at risk if you don’t keep up with your repayments.

Benefits of a loan

There are several benefits to having a loan. You can often borrow more with a loan than an overdraft, for example. So loans are more suitable for people looking for higher sums of money, with repayments spread over a few years.

The cost of borrowing usually works out cheaper over the long term, compared to an overdraft, as interest rates tend to be lower for larger sums of money.

The payments are fixed, which means you pay the same amount each month, including the interest. This makes budgeting easy, as you always know where you stand.

Disadvantages of a loan

Loans are less flexible than overdrafts, as you cannot withdraw money as and when you need it. You get a fixed lump sum to spend and then you make set repayments each month. If you miss a payment or make a late payment, your credit score can be affected.

Secured loans are secured against your home, which means your property can be used to recover the debt if you can’t maintain your repayments. So it’s best to weigh up your options and speak to an advisor before going ahead. The larger the loan, the longer it may take to pay it back.

Unlike personal loans which can be approved within 24 hours, secured loans can take several weeks to be approved. This is because more paperwork is required by the lender to support your application.

Is it cheaper to get a loan or an overdraft?

Make sure you shop around to find the most affordable option to suit your individual circumstances. Interest and charges vary on different overdrafts and loans.

Overdrafts may charge higher interest and charges compared to loans. There are 0% interest deals out there, but eligibility depends on your financial circumstances and the lender’s criteria. They are usually reserved for people with good credit scores. Also, any 0% interest offer may only be valid for a certain period of time, after which interest and charges become applicable, or for a small amount (around £250).

Regarding loans, you’ll generally be charged less interest on larger loans than on overdrafts, but you may end up paying more interest on smaller amounts. Also, if you want to clear the balance on a loan early, you may face early repayment charges (depending on the terms and conditions). These charges don’t apply to overdrafts.

The best way to compare the overall cost of borrowing is to check the APR, which is normally shown as a percentage. Before you apply, make sure you use eligibility checkers to see if you’ll be accepted, without affecting your credit score.

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