Which Is Better – A Loan Or An Overdraft?

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If you’re looking to borrow money, you might be weighing up whether a loan or an overdraft is the better choice. We examine both options to help you make a decision that’s right for you.

What is a loan?

A loan typically enables you to borrow a fixed amount of money over a fixed period of time (known as the ‘term’) – often somewhere between one and five years, although some providers will stretch this up to seven years or even more.

You then repay the amount borrowed in monthly instalments with interest added on top. Interest rates may be fixed for the duration of the term, which means you know how much your repayments are going to be, or they may be variable according to prevailing market conditions.

Who is a loan suitable for?

Loans can be a good option if you’re looking to fund home improvements, pay for a new car or consolidate existing debt. You can usually borrow anywhere between £1,000 and £25,000.

Choosing a personal, unsecured loan is less risky than a secured loan, which will require you to use an asset such as your home as collateral.

Should you take out a secured loan and struggle to keep up with your repayments, your lender has the legal right to repossess your property and force you to sell your home.

However, secured loans often allow you to borrow larger amounts (more than £25,000), and interest rates can also be lower because they are less risky for lenders because of the collateral they can fall back on.

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What is an overdraft?

Overdrafts enable you to borrow money through your bank account, up to a certain limit, with no set repayment date. Some overdrafts may be interest-free, but more often you’ll be charged interest on the amount borrowed. Interest rates are usually variable.

An arranged or authorised overdraft is a pre-agreed limit with your bank, and you can spend up to that limit.

An unarranged or unauthorised overdraft is when you spend more than you have in your current account and have not agreed an arranged overdraft limit with your bank, or when you go over the limit of an arranged overdraft.

New rules introduced in April 2020 mean that banks can no longer charge higher fees for unauthorised overdrafts than for authorised overdrafts.

Who is an overdraft suitable for?

Because overdraft borrowing limits are usually much lower than with a loan (usually somewhere between £500 and £2,000), an overdraft is best suited to short-term borrowing – for example, if you need to pay for emergency costs or to help see you through until your next payday.

What are the pros and cons of a loan?

Pros

  • Funds can be approved quickly – often within 24 hours
  • Monthly payments are fixed, making it easier to budget
  • You can choose the repayment term, usually up to five years but sometimes longer, making it a good option for long-term borrowing
  • Interest rates can be competitive, particularly on loan amounts of £7,500 or more
  • You can usually borrow a larger sum of money than you could through an overdraft.

Cons

  • Payments are not flexible so if you regularly miss monthly repayments this could negatively affect your credit report
  • If you’re only looking to borrow a relatively small sum, say £2,000, interest rates can be much higher than on sums of £7,500 or more
  • Some loans are secured against your home, putting the roof over your head at risk if you can’t keep up with repayments
  • There may be expensive early repayment charges.

Pros and cons of an overdraft

Pros

  • Payments are flexible
  • You have the option to increase, decrease or cancel your overdraft at any time
  • There is no repayment term – you can pay back the amount borrowed as and when you wish
  • You can dip in and out of your overdraft as required.

Cons

  • Interest rates can be high, making it a costly way to borrow
  • Borrowing limits are much lower than with a loan
  • Your bank can reduce the limit or cancel your overdraft at any time
  • As there is no repayment term, it can be easy to stay in your overdraft permanently.

Which is right for me? 

If you’re looking to borrow a few hundred pounds, perhaps to cover boiler repairs for example, an overdraft can be a useful option.

The application process is quick and easy – you can usually do it from a banking app. Your bank will usually run some affordability checks before letting you know how much you can borrow. If approved, your overdraft will often be ready to use immediately or if not, within a few days.

To save money, it’s best to look for an overdraft that’s interest-free – at least for a set time – which may mean switching your current account. Nationwide’s FlexDirect current account, for example, offers an interest-free overdraft of up to £1,500 for 12 months.

Make sure you check the small print carefully, however, as you will often need to meet certain qualifying criteria and pay in a set amount each month. Nationwide requires you to pay in at least £1,000 a month.

If you can’t get an interest-free overdraft, you may want to consider paying off your overdraft as soon as you can to avoid high interest charges.

If, on the other hand, you need to borrow a much larger amount, perhaps to fund important or substantial home improvements, a loan is likely to be a better option.

Should you need to borrow a sum of over £25,000 you may want to consider a secured loan, but remember you will be putting your home at risk so it’s not a decision to take lightly.

Whichever loan you choose, make sure you have a repayment plan in place and that you can afford to make your monthly payments on time each month. Failure to keep up with your repayments can negatively affect your credit score and affect your chances of getting credit again in the future.

Are there any alternatives?

Another popular way to borrow is with a credit card. The type of credit card you choose will depend on what you need it for.  

0% purchase credit card, for example, will allow you to spread the cost of a purchase interest-free over several months, while a 0% balance transfer credit card can be a good choice when it comes to consolidating existing card debt more cheaply.

0% money transfer credit card, meanwhile, enables you to move funds from your credit card into your current account and then use this money to pay off debt or to fund a purchase.

Just bear in mind that once the 0% deal ends, interest will kick in and most balance transfer and money transfer cards charge a transfer fee.

Credit cards also typically only allow you to borrow a few hundred or few thousand pounds, so the limit may not be high enough to meet your requirements.

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