Overdraft vs Loan: Difference and Comparison

An overdraft is a revolving line of credit that allows a bank account holder to withdraw more money than is available in the account, while a loan is a fixed amount of money borrowed from a financial institution that is repaid in installments with interest.

Key Takeaways

  1. Overdrafts provide short-term access to borrowed funds through a bank account, while loans involve borrowing a fixed amount for a predetermined period.
  2. Interest rates for overdrafts can be higher than loans, making them costlier for long-term borrowing.
  3. Overdrafts offer flexible repayment with no fixed schedule, whereas loans have a structured repayment plan.

Overdraft vs Loan

An overdraft is a short term loan in which the bank account holder can withdraw a larger amount than their present bank account amount. A loan is a borrowed amount of funds or capital that a bank or financial institution lends to an organization or individual for a specific time.

Overdraft vs Loan
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Comparison Table

AspectOverdraftLoan
DefinitionA financial arrangement that allows an account holder to withdraw more money than the account balance, up to an agreed-upon limit.A lump sum of money provided by a lender to a borrower, which is repaid over a specific period, with interest.
PurposeShort-term financing for temporary cash flow needs or to cover occasional expenses.Used for various purposes, including long-term investments, purchases, or financing specific projects.
RepaymentFlexible repayment: The borrower repays the overdraft as and when funds become available. Interest is charged on the outstanding balance.Fixed repayment schedule: Borrower makes regular payments (installments) of principal and interest over a predetermined period.
InterestInterest is charged only on the outstanding overdraft balance and is higher than loan interest rates.Interest is charged on the entire loan amount, which can be a fixed or variable rate, lower than overdraft rates.
Approval ProcessTypically easier and quicker to obtain, with lower documentation and credit checks.Often involves a more rigorous approval process, including credit checks, financial assessment, and documentation.
Credit LimitUsually has a predefined credit limit that the account holder can access within the overdraft facility.The loan amount is determined at the time of approval and may be the full requested amount or a portion of it.
TermNo fixed term; can be open-ended as long as the account holder remains eligible and repays the outstanding balance.Has a specific loan term, ranging from months to years, depending on the type of loan.
Security/CollateralMay or may not require collateral, depending on the type of overdraft (secured or unsecured).Can be secured or unsecured. Secured loans require collateral as security.
Use of FundsOverdraft funds can be accessed and repaid repeatedly as needed, up to the credit limit.Loan funds are disbursed once and must be used for the specified purpose.
Risk of Over-BorrowingRisk of over-borrowing due to easy access to funds; interest charges can accumulate quickly if not managed properly.Borrowing is for a specific purpose, reducing the risk of over-borrowing.
Typical ExamplesChecking account overdraft, business line of credit, or personal overdraft facility.Personal loans, mortgage loans, auto loans, business loans, student loans, etc.
Common LendersBanks, credit unions, and financial institutions offer overdraft facilities.Banks, credit unions, online lenders, and specialized loan providers offer various types of loans.

What is Overdraft?

An overdraft is a financial arrangement offered by banks and financial institutions that allows an account holder to withdraw more money from their bank account than the actual available balance. In essence, it permits individuals or businesses to borrow funds temporarily, creating a negative balance in the account up to an agreed-upon limit.

Key features of an overdraft include:

  1. Credit Limit: The bank or financial institution sets a predetermined credit limit for the overdraft facility. The account holder can withdraw funds up to this limit, even if insufficient funds exist.
  2. Flexible Repayment: Overdrafts do not have a fixed repayment schedule like traditional loans. Instead, the account holder repays the borrowed amount, along with any interest and fees, as funds become available in the account. There is no fixed installment or specific repayment date.
  3. Interest Charges: Interest is charged on the outstanding negative balance of the overdraft. The interest rate can vary and is higher than the interest rates for traditional loans.
  4. Approval Process: The approval process for an overdraft is simpler and quicker than obtaining a traditional loan. It may require a credit check, but the requirements are less stringent.
  5. Usage: Overdraft funds can be accessed and repaid repeatedly as needed, as long as the account holder remains within the credit limit and is eligible for the overdraft facility.
  6. Fees: Besides interest charges, some banks may impose fees, such as overdraft fees or service charges, for using the overdraft facility.
Overdraft

What is a Loan?

A loan is a financial arrangement in which one party, a lender (such as a bank, credit union, or online lender), provides a specific amount of money to another party, known as the borrower, with the expectation that the borrowed funds will be repaid over time, with interest. Loans are common in both personal and business finance and serve various purposes, including making purchases, funding investments, or covering specific financial needs.

Key features of loans include:

  1. Principal: The principal is the initial amount of money borrowed by the borrower. It represents the total amount of funds provided by the lender.
  2. Interest: Interest is the cost of borrowing money and is expressed as an annual percentage rate (APR). Borrowers must repay both the principal and the accrued interest over the loan term.
  3. Loan Term: The loan term is when the borrower is obligated to repay the loan. Loan terms can vary widely, ranging from a few months to several decades, depending on the type of loan.
  4. Repayment Schedule: Loans have a predetermined repayment schedule, specifying the amount and frequency of payments. Common repayment schedules include monthly, quarterly, or annual payments.
  5. Secured vs. Unsecured: Loans can be categorized as secured or unsecured:
    • Secured Loans: Secured loans are backed by collateral, such as a home (mortgage loan) or a vehicle (auto loan). If the borrower fails to repay the loan, the lender can seize the collateral.
    • Unsecured Loans: Unsecured loans do not require collateral. Lenders assess the borrower’s creditworthiness to determine eligibility, and these loans have higher interest rates than secured loans.
  6. Purpose: Loans can serve various purposes, including:
    • Personal loans for general expenses.
    • Mortgage loans to purchase real estate.
    • Auto loans to finance the purchase of vehicles.
    • Student loans for educational expenses.
    • Business loans for business-related investments and operations.
    • Credit card loans for revolving credit.
  7. Credit Check: Lenders perform a credit check on the borrower to assess their credit history, credit score, and loan repayment ability. Creditworthiness can affect the loan approval process and interest rates.
  8. Loan Agreement: Borrowers and lenders enter into a formal loan agreement that outlines the terms and conditions of the loan, including interest rates, repayment terms, and any applicable fees or penalties for late payments.
  9. Amortization: The repayment structure is amortized for loans with fixed interest rates, meaning that each payment consists of both principal and interest. Over time, the proportion of the payment allocated to principal increases, while the interest portion decreases.
Loan

Main Differences Between Overdraft and Loan

  1. Purpose:
    • Overdraft: Overdrafts are used for short-term financing, covering temporary cash flow shortages, or avoiding declined transactions and bounced checks.
    • Loan: Loans can serve a wide range of purposes, including making large purchases, financing investments, funding education, buying a home (mortgage loan), or running a business.
  2. Structure:
    • Overdraft: An overdraft is a revolving line of credit linked to a checking account. It allows account holders to withdraw more money than is currently available in the account, up to an agreed-upon limit.
    • Loan: A loan is a lump sum of money a lender provides to the borrower. Loans have a fixed principal amount, and the funds are disbursed once, with the borrower receiving the full loan amount upfront.
  3. Repayment:
    • Overdraft: Repayment of an overdraft is flexible, with no fixed schedule. The borrower repays the borrowed amount and interest as funds become available in the account. There is no fixed installment or specific repayment date.
    • Loan: Loans have a structured repayment schedule, specifying the amount and frequency of payments. Borrowers make regular payments (installments) of principal and interest over a predetermined period.
  4. Interest:
    • Overdraft: Interest on an overdraft is charged on the outstanding negative balance. Overdraft interest rates can be relatively high compared to loan interest rates.
    • Loan: Interest is charged on the entire loan amount. Loan interest rates can vary but are lower than overdraft rates.
  5. Credit Limit:
    • Overdraft: Overdrafts have a predefined credit limit that account holders can access within the overdraft facility.
    • Loan: The loan amount is determined at the time of approval and may be the full requested amount or a portion of it, depending on the borrower’s needs and eligibility.
  6. Approval Process:
    • Overdraft: Overdrafts have a simpler and quicker approval process, with lower documentation and credit check requirements.
    • Loan: Loans involve a more rigorous approval process, including credit checks, financial assessments, and documentation.
  7. Secured vs. Unsecured:
    • Overdraft: Overdrafts can be secured (backed by collateral) or unsecured (based on the account holder’s creditworthiness).
    • Loan: Loans can be secured or unsecured. Secured loans require collateral as security.
  8. Usage:
    • Overdraft: Overdraft funds can be accessed and repaid repeatedly as needed as long as the account holder remains within the credit limit and is eligible for the overdraft facility.
    • Loan: Loan funds are disbursed once and must be used for the specified purpose, such as buying a home, car, or financing a project.
Difference Between Overdraft and Loan

Last Updated : 13 February, 2024

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